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The Differences Between the Centralized and Decentralized Cryptocurrency Exchanges

With the proliferation and the growth of the cryptocurrencies, the necessity for having new places where to mobilize, negotiate and store the cryptocurrencies this growth. This way the cryptocurrency exchanges appeared on the market and have quickly become the main channels to perform negotiations with cryptocurrencies and exchange them for fiat money or other cryptographic currencies. Over time, the cryptocurrency exchange platforms were incorporating a variety of functions.

These new exchanges platforms started operating as centralized businesses, with characteristics similar to the ones of the traditional bank, despite the decentralized character of the cryptocurrencies and their underlying blockchain technology. Nevertheless, the very growth of the cryptocurrency ecosystem encouraged the development of the decentralized cryptocurrency exchange platforms.

Two categories of the cryptocurrency exchange platforms have developed over time: the centralized exchange platforms (CEX) and the decentralized platforms (DEX) and each of them has its own particular characteristics and features.

Many of the well-known cryptocurrency exchanges are centralized, such as Bittrex, Coinbase, Poloniex, Kraken, Bitstamp, Binance, Bitfinex and others. These cryptocurrency exchange platforms serve as an intermediary between two persons that would like to perform an exchange involving cryptocurrencies.

As the cryptocurrency market was growing, the first centralized exchange businesses started performing a number of functions that moved them in the direction of the classic financial intermediation, where they perform many functions of the traditional banks, but adapted to the cryptocurrency ecosystem.

This intermediation includes the conversion of fiduciary money to digital currencies, which is one of their featured activities, which is why the centralized cryptocurrency exchange platforms need to interact with regulatory entities in order to operate the parities between fiduciary money and cryptocurrencies. With the appearance of the altcoins, the cryptocurrency exchanges started advancing towards the exchange between cryptographic pairs.

The centralized cryptocurrency exchange platforms also offer different types of wallets where the users can storage their funds, sometimes even with a secured custody. This is the case of Coinbase, the cryptocurrency exchange that insures the funds of the users up to 250,000 US dollars. Moreover, Coinbase recently launched new products for the custody and investment in cryptocurrencies.

Some of these options are getting incorporated by the majority of the large exchange platforms that offer trading options to a wider market. Many of these cryptocurrency exchange platforms deal with a large volume of transactions and liquidity, counteracting that way the volatility of the cryptocurrency market.

The backup is another advantage of the centralized cryptocurrency exchanges. As intermediary entities these cryptocurrency exchange platforms can help the user in case of loss of passwords and key data, after verifying the user first, of course.

On the other hand, the management of the identification data of the users has a counterpart, because the centralized cryptocurrency exchanges are subject to regulation, they need to adopt the measure against money laundering and financing of terrorism through the Know Your Client (KYC) policies.

This way, when opening an account on the exchange platform, the users need to provide a significant amount of personal information that should be verified and stays at disposal of the company. Despite the privacy policies offered by the companies, the possibility of identity theft remains open.

One of the main characteristics of the centralized cryptocurrency exchanges is that the user is not the owner of the cryptocurrencies that he or she acquired or exchanged, because the users does not have the private key to access the funds. Moreover, the data and performed operations are maintained on a centralized server.

This is one of the major disadvantages of the centralized cryptocurrency exchanges because it presents a major vulnerability in case of hacker attacks or frauds performed by cyberdelincuents. We have seen a number of happenings in the past that brought a lot of damage to the investors.

One of the most notable examples is the case of Mt. Gox, a cryptocurrency exchange platform that controlled more than 70% of the transactions with bitcoins at one point. Thousands of users lost their money when 850,000 bitcoins disappeared back in 2014, although 200,000 bitcoins were found last year.

A mixture of risks was present in the case of Mt. Gox. First, Mark Karpelès, the executive director of the company, reported he was a victim of an attack on the platform. The subsequent investigations later detected possible alterations of the cryptocurrency balances that led to robbery accusations.

A different, but equally serious attack was pointed against Bitfinex back in 2016 when 216,000 bitcoins were stolen. Moreover, a malicious bot provoked a massive sale of tokens on Binance in March this year, without the authorization of the affected users.

These and many other cases provoked the governments around the world to put more pressure on the centralized cryptocurrency exchange platforms by introducing strict regulatory measures. In many countries around the globe, the cryptocurrency exchanges are subject to audits, legal controls, tax payment and other requests that could mean limitations, moving and even closure.

In this sense, it is worth mentioning the 13 cryptocurrency exchanges currently being investigated by the Attorney General of New York, the audits of Upbit in South Korea and the companies that emigrated from New York back in 2015 because they could not obtain the BitLicence, which was a legal requirement to continue doing business. Likewise, in some case the platforms shut down completely or had their funds confiscated, such as in the case of BTC-e, presumably because the platform was used to launder the funds stolen during the Mt. Gox attack in 2014.

Even so, the regulation has an important advantage when it comes to facilitating the legal claims in case of irregularities in the functioning of the cryptocurrency exchanges or lost funds. The governmental investigations and arrests of some executives, such as in the case of Mt. Gox and BTC-e, could lower the risk of impunity in the face of possible crimes.

Contrary to the centralized cryptocurrency exchanges, a decentralized cryptocurrency exchange platform (DEX) functions without an intermediary and operates in an environment maintained by a software through which it interacts with different blockchain networks. There is no necessity for a third party in order to perform the exchange since the exchange operations are realized between peers (Peer-to-Peer or P2P).

Exchange platforms such as Ox, ShapeShift, OpenLedger, Waves, EtherDelta, Bitsquare, Changelly and others are decentralized cryptocurrency exchanges where the users can negotiate the exchange directly between themselves.

In these cases it is not necessary to trust the funds to a company, which is why the decentralized cryptocurrency exchange platforms normally do not offer custody services. Some platforms though, such as Waves, have the wallet option, but the clients control their keys and money. The users also have the option to use their private wallets to transfer the funds and execute the transactions.

The governmental regulations do not apply in the case of the decentralized cryptocurrency exchange platforms, which gives them a more universal and deregulated character, with the control in the hands of the participants on the cryptocurrency market. Nevertheless, it increases the level of anonymity and many transactions are hard to track and regulate, because a minimum of personal data is required to register and open an account on this type of exchange platforms. On some platforms, such as Bitsquare, the users do not even need to register.

Precisely because of this characteristic is why many of the regulators are questioning this type of cryptocurrency exchange platforms, because they consider they can be used for the money laundering and illicit activities.

It is worth mentioning that the decentralized cryptocurrency exchanges are not exempt from hacker attacks, because their servers are connected to the internet. EtherDelta suffered a hacker attack in December last year which revealed some data of its users, even though it was quickly detected by the Ethereum blockchain network.

On the other hand, even though the majority of the decentralized cryptocurrency exchange platforms could be limited when it comes to performing exchanges between cryptocurrencies and fiat money, they also have the advantage of dealing with a variety of tokens that could be exchanged and they often list the most recent tokens released through initial coin offerings (ICOs). The centralized cryptocurrency exchanges, however, many times have difficulties to include these new cryptocurrencies, due to regulatory restrictions.

When it comes to the difficulties to perform the exchange to fiduciary money, some decentralized platforms offer the alternative to exchange cryptocurrencies with stable cryptocurrency, the so-called stablecoins. This option is offered by ShapeShift, where the users can perform transactions with the BitShares cryptocurrencies, such as BitCNY.

The freedom to establish prices is another important characteristic of the decentralized cryptocurrency exchanges, where the participants on the market can act under more flexible rules of supply and demand. Likewise, the commissions for transactions tend to be lower than the commissions when using the centralized cryptocurrency exchange platforms, which makes the entire process of exchange more economic.

The development of decentralized exchange platforms has been growing in the last years, which does not necessarily mean the centralized cryptocurrency exchanges are losing their popularity. Decentralized alternatives have been developed in diverse service areas inside the emerging cryptocurrency ecosystem.

Brian Armstrong, the co-founder of Coinbase, recently expressed his opinion on this matter in an article published on his corporate blog. He explains the centralization is a necessary phase that would lead to the decentralization. The goal of the article was to explain the company’s strategy, especially after the acquisition of Paradex, a decentralized cryptocurrency exchange platform bought by Coinbase. Armstrong said: “An employee asked me recently how we’re creating an open financial system if we’re a centralized company. It’s a good question and here was my answer.

People need to be able to do both of the following:

Get access to cryptocurrency — this tends to be more centralized

Use cryptocurrency — this tends to be more decentralized

Coinbase has products in both of these areas, and the first one helps the second one happen.”

The co-founder of Coinbase plants the idea of an open financial system in which both the centralized and decentralized cryptocurrency exchanges coexist. Armstrong explains: “Adoption of cryptocurrency will happen in several phases.

In the investment phase people speculate and try to make money on crypto. This is where 90% of activity is happening today, primarily via centralized exchanges.

In the utility phase people begin using crypto as a payment network, transacting for real goods and services, interacting with dapps, etc. This is where about 10% of activity is happening today, primarily via decentralized (user controlled) wallets.

In other words, the investment phase draws enough people in that a critical mass of people is reached to spark the utility phase, or come for the tool, stay for the network.”

Finally, he concludes with the following: “The overall point is that there will be both centralized and decentralized products which help create an open financial system, just like ISPs (centralized) and browsers (decentralized) both play a key role in the internet ecosystem. It’s a false dichotomy to pit one against the other because both are a part of the solution.

Coinbase will continue creating both centralized and decentralized products that help accelerate the adoption of an open financial system.”

Armstrong’s opinion differs a little bit than the opinion of other developers, such as Nick Szabo. According to Szabo, the decentralized cryptocurrency exchange platforms are fundamental, they define the blockchain technology and should completely substitute the traditional intermediaries. However, it will probably take some time before the decentralized cryptocurrency exchanges replace the centralized cryptocurrency exchanges.

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