What is a cryptocurrency exchange?
Cryptocurrency exchanges are the backbone of the crypto market. They facilitate crypto commerce by providing a platform where the assets can be traded and exchanged. In this cryptocurrency market, there are two types of exchange platforms; centralized and decentralized.
Within the crypto/digital currency market, the exchanges facilitate the conversion of fiat into crypto and vise versa. Also, the exchanges enable different cryptos to be exchanged within the platform.
A centralized exchange is a third party exchange platform that brings individuals and institutions looking to exchange or trade together. The main role of such an exchange is to reduce friction related to exchange by providing liquidity and convenience through an account which holds funds and user positions.
These exchanges hold funds for the users, their private keys and facilitate trading. The huge amounts of money held in these exchanges attract a lot of hackers who drain funds from these centralized exchanges. Examples of such exchanges include; Bittrex, Binance, Coinbase and others.
These are commonly referred to as (DEXs).
This type of exchange does not have any controlling party or server. There are no third-party escrow intermediaries in these exchanges to hold the funds of the participants during transactions. Dexs are structured in such a way that users retain ownership of their private keys and coins. Therefore, cryptocurrencies are not accumulated in one centralized point, which can reduce attacks and hacking. Examples of DEXs include; IDEX, Waves DEX, Bisq and others.
Differences between centralized and decentralized exchanges
In centralized exchanges, users rely on the platform to authenticate and authorize their transactions. The platform acts as a third-party intermediary which provides trusted cryptocurrency exchange services.
DEXS do not rely on third-party intermediaries. They use smart contracts and an implementation of different blockchain protocols to provide trustless authentication and authorization of crypto exchange transactions.
- Control of funds
In order for users of centralized exchange platforms to facilitate an exchange, they need to make a deposit to the exchange. These funds are controlled by the centralized exchange service. The centralized exchange platform therefore retains the order books as well as custody of the funds.
In decentralized crypto exchange platforms, users transact directly with others without the interference or need for a central server. These exchanges do not have a centralized platform that controls the order books and custody of the funds. Users and participants in the platform control the funds.
Previously, certain centralized exchanges used to allow anonymous accounts on their platforms. This was later prohibited due to the government regulations which have been evoked in recent months. These have led to strict AML and KYC laws hence it is difficult to trade anonymously on the centralized crypto exchange platforms.
Decentralized crypto exchanges have been created to promote anonymity. Users on these platforms can buy, sell or exchange cryptocurrencies without revealing their identity on the platform. This further protects not only their identities but also their assets.
Advantages of decentralized cryptocurrency exchanges
- Seamless integration with secure Hardware Wallets
Some decentralized exchange platforms offer seamless integration with some hardware wallets such as Ledger Nano S and Trezor ensuring a much safer transaction space. Users are able to send their tokens or coins from their hardware wallets directly to the smart contracts of these decentralized exchanges.
This feature is not available in centralized exchanges since users have to manually enter their private keys so as to move coins from their hardware wallets to the centralized exchanges. Such an action puts the users of centralized exchanges at a high risk of malicious phishing and keylogging attacks.
- Faster and cheaper transactions
Decentralized exchanges provide platforms which promote faster, cheaper and more cost effective trading and exchange transactions. The lack of the third-party authenticators and escrow service providers reduce fees and lag time which exists in centralized exchanges before order are processed.
Decentralized exchanges do not have a single point of failure or entry, just like the blockchain. As such, hackers will need to compromise more than half the network in order to be able to control the platform. Additionally, users control their funds and their private keys. Therefore, there are no large amounts of coins held in one exchange which attracts the hackers.
- Users control their funds
DEXs are owned and controlled by all the participants hence there is no central server, corporation or individual who has custody of deposits and private keys. Users have the control of their funds since these platforms use P2P network architecture. The transactions on the platform take place between users on the platform through smart contracts which are only controlled using private keys of the users.
Disadvantages of decentralized exchanges
Decentralized exchanges work by allowing people to individually set and take orders. These orders are put on different order books which are hosted independently of each other. Orders placed on one order book cannot appear on another. Therefore, there is an issue as users suffer from lack of liquidity. Liquidity is a measure to which an asset can be quickly bought or sold in the market without this process affecting its price. Without liquidity, users may have to look at different books to place their order, which affects the speed in which the cryptocurrencies can be bought and sold within the exchange.
- Difficult to use
At present decentralized exchanges do not have a simple user interface and user experience for the participants. Because of this, they suffer a limited reach as compared to the centralized exchanges. The excess smart contracts that users need to navigate in order to use these DEXs can be complicated. Also, some of the decentralized exchanges have confusing exchange dashboard which can put off users who have difficulty navigating hence they result to using the centralized exchanges.
- Low trade volume
Decentralized exchanges have low transaction volumes hence it is hard to find other parties to trade with. Without a huge amount of users and tokens listed, buying and selling will be low hence the trade volume cannot compare to that in the centralized exchanges.
- Limited functionality
DEXs offer limited functionality when compared to centralized exchanges. These exchanges suffer limitation in order type since there is no limit order available and also because there is no breadth of tradable coins caused by lack of trade volume.
Most DEXs only support basic cryptocurrency exchange function. They do not have more advanced trading tools and features such as margin trading and stop loss. This has resulted to their slow adaptation by the marketplace.