Binance released its highly anticipated proof of reserves (PoR) on Friday, providing blockchain-based evidence for the Bitcoin on its books. However, many in the crypto community question Binance’s approach, and aren’t fully convinced that they have the transparency they’re looking for. The Move to Proof of Reserves As Binance explained in its announcement, the exchange’s transparency system will add multiple tokens and networks within the next two weeks. For now, it solely validates its Bitcoin holdings. The company’s initial audit…
How is trading cryptocurrencies different from trading any other assets like fiat currency, stocks, or bonds? There are quite a few distinctions, but the main difference is that cryptocurrencies have their own trading exchanges, which are either centralized or decentralized.
In recent years, cryptocurrencies have grown in popularity and adoption. This is because they offer super cheap borderless ways of sending and receiving money and new investment opportunities. Additionally, many people migrate to cryptocurrencies as stores of value to protect their wealth from individual and collective government inflation.
This guide offers a detailed comparison between centralized and decentralized exchanges and attempts to show why the future might lean more towards further adopting decentralized exchanges.
Centralized Exchanges (CEXs)
Cryptocurrency exchanges enable people to buy or sell fiat for crypto or vice versa and exchange one crypto for another. Today, more than 90% of all crypto trading activity takes place on centralized exchanges. They have the largest share by market capital and offer more liquidity than decentralized exchanges, making them more popular.
Users usually have to create an account with a particular exchange, which acts as an escrow service to oversee a transaction on both sides. They also require that you transfer your crypto from a personal cryptocurrency wallet to your account’s wallet.
Similarly, if you buy crypto with fiat, the exchange holds your new crypto inside the account’s wallet. It is usually easier and convenient if you’re looking to start trading but otherwise advisable to transfer your funds to a personal cryptocurrency wallet, which is much safer and secure and can only be accessed by you.
The good thing about such exchanges is that they are fast, offer a wide range of cryptocurrency and fiat pairs, and cheap transaction fees. They also offer various trading tools, simple interfaces, and various methods to buy crypto using fiat, making them flexible and highly convenient.
Centralized Exchanges Risks
Centralized exchanges are third-party services providers that enable traders to buy and sell fiat or crypto using various compatible trading pairs. However, this goes against the very essence of crypto technology, which is decentralization, eliminating third-party services, and the accompanying financial shift and influence.
Their centralized structure presents some risks, one of them being susceptibility to hacking. Dozens of centralized exchanges have been hacked in the past decade, where the perpetrators have managed to get away with cryptocurrencies worth hundreds of millions.
Some crypto experts have been advocating for “Not Your Keys, Not Your Crypto” or Not your Keys, Not Your Bitcoin” to show the dangers of centralized exchanges. Apart from hacking, if an exchange were to shut down immediately, that would cause anyone with crypto held up inside the exchange to lose their money. Several exchanges in the past have also done this, causing losses to millions of investors.
Decentralized Exchanges (DEXs)
Decentralized exchanges carry the true spirit of Decentralized Finance (DeFi). They are decentralized trading platforms that automate the whole buy and sell process using smart contracts.
Users trade directly from their wallets on a distributed ledger network and eliminate the single point of failure present in centralized exchanges.
Decentralized exchanges have been around as long as centralized ones, but they have been less popular and slower in development for various reasons. Various concepts of DEXs have used different approaches over the years, but they all have two things in common.
First, they eliminate the need for users to hand over their funds to a third party, and they trade crypto-to-crypto. That means, for now, people would still need centralized exchanges to trade crypto with fiat.
Another unique thing about DEXs is the possibility of real-time (on-chain) Atomic Swaps, which means users can transfer cryptocurrencies across different blockchain ecosystems. This is because even though blockchain networks are decentralized, they are still stand-alone software that cannot simultaneously be interoperable with others, for now.
Several DEXs have been built on the Ethereum blockchain ecosystem, the biggest smart contract developer platform today. One of the oldest DEX on Ethereum is EtherDelta, which lets users trade Ether (ETH) tokens and Ethereum-based (ERC-20) tokens.
Another popular DEX that is more of a hybrid exchange is IDEX, which lists almost 400 coins and has substantial liquidity. Hybrid exchanges try to minimize the power of centralized exchanges by introducing decentralized governance while maintaining the convenience of CEXs.
Verdict: DEXs is the Future of Crypto Exchanges
Trace Meyer is an avid Bitcoin investor, founder of Bitcoin Knowledge podcast, and the face of Proof of Keys website has been advocating for private bitcoin ownership. On Jan 3rd, 2020, in commemoration of when the first Bitcoin block was mined, he urged bitcoin owners to withdraw their funds from exchanges, which he claimed held 1.925+M BTC.
Meyer continues to promote the core principle of cryptocurrency technology, which is decentralized governance, meaning that transactions move wallet to wallet without a middle man’s involvement.
DEXs are trying to do this, but their interfaces can be a little intimidating to beginner-level users since they require substantial knowledge of how crypto networks function; otherwise, it’d be easy to lose money.
Much development is currently underway, especially with advancements in smart contract technology, which will enhance scalability and more use cases. Crypto information and interest is also growing first, and more people will start appreciating the power that comes with being their own banks.
Centralized exchanges are actually playing a critical role in crypto adoption. Still, as more people use them and leave their funds on them, they threaten the whole doctrine of the decentralized concept of cryptocurrencies.
On the other hand, DEXs offer their wallet-to-wallet trading advantages, but they are not as popular and easy to use as centralized exchanges. Technological advancements and the existence of hybrid exchanges will introduce ways for users to keep ownership of their funds and still have the ease and convenience of transactions.