Buying/selling crypto: Centralized vs decentralized exchanges
It is entirely possible to get into cryptocurrency for the first time without ever utilizing an exchange. You could get a digital wallet and then be gifted some bitcoins by a friend hoping to introduce you to playing slots online. But by and large, most people are introduced to crypto when they use an exchange to purchase their first round of coins.
Exchanges are online platforms created to facilitate the buying and selling of digital tokens. Just about every exchange on the planet deals in the top 5-10 cryptos including Bitcoin, Litecoin, Bitcoin Cash, and Ethereum. Smaller numbers dabble in the lesser-known coins. The one thing they all have in common is that they bring together buyers and sellers to facilitate transactions at a fee.
There are two kinds of exchanges we want to deal with in this post. They are centralized and decentralized. Both have their pros and cons, though centralized exchanges far outnumber their decentralized counterparts. There seems to be a growing consensus within the crypto community that more decentralized exchanges are needed. Time will sort that out by itself. As for the differences, let us talk about them in detail.
The centralized exchange
A centralized exchange, also known as a CEX, is considered the traditional exchange in that it was the first kind of commercially available exchange. It is governed by a single entity. That entity may be an individual who has created an online platform for buying and selling. It could be a company as well, or even a consortium of miners who have pooled their computing and financial resources to operate an exchange.
This sort of exchange is designated as centralized because control is not given to the entire community. Like cryptocurrencies themselves, exchanges are built on computer code that controls all of the transactions occurring on that exchange. The question is, who controls the code?
The entity or organization that operates a centralized exchange controls its code from top to bottom. If that entity chooses to alter the code for whatever reason, it can do so without putting said changes to a vote. The idea behind this sort of arrangement is rooted in the fact that the exchange is a business rather than a community project. As such, business interests are controlled by the entity that owns and operates the exchange.
- Advantages of centralization
There are both advantages and disadvantages to centralization within the exchange environment. One of the biggest advantages of central exchanges is that they are capable of handling extremely high trade volumes. This is possible because they have a lot of money backing them. Without money in the bank, so to speak, an exchange can't handle larger volumes.
Other advantages include:
- Higher Liquidity - The money backing centralized exchanges generally results in high liquidity as well. Note that liquidity is a sign of strength in financial circles.
- Fiat/Crypto Pairs - Centralized exchanges can offer fiat/crypto pairs. In other words, you can buy crypto with fiat and vice-versa.
- Better Function - Centralized exchanges tend to offer better function inasmuch as they offer more tools, more options, increased reliability, etc.
All of these advantages do come at a cost. Some of the highest transaction fees in the cryptocurrency space are found on centralized exchanges.
- Disadvantages of centralization
The chief disadvantage of centralization is found in governance. The fact that a single entity or organization controls an exchange does make for a more sound business model and greater financial stability, but it runs counter to the decentralized nature of cryptocurrencies themselves.
Centralized exchanges are also more vulnerable to security breaches by nature. With so many more moving parts, it is just more difficult to keep things safe. And if that's not worrisome enough, centralized exchanges are generally regulated by government. That means they can be shut down if they run afoul of regulations, thereby putting the assets of traders at risk.
The decentralized exchange
The decentralized exchange is also known as a DEX. As you might expect, it is an exchange that is not owned or governed by a single entity. It follows the same decentralized and community-driven philosophy of a pure cryptocurrency. As such, it does not depend on the strength of a single entity or organization to exist.
One of the key components of the decentralized exchange is that its assets are not held or controlled by the exchange itself. Trades are considered peer-to-peer inasmuch as they go from one wallet to the next without any intermediary. The exchange itself is simply an introductory platform where buyers and sellers find one another.
Security in a decentralized environment is insured by the same blockchain principles that keep platforms like Bitcoin and Ethereum secure. It is interesting to note that most of the decentralized exchanges out there are built on the Ethereum blockchain.
One last thing to note here are the importance of smart contracts within the decentralized environment. Smart contracts essentially automate the process of buying and selling tokens. It is safe to say that a decentralized exchange would not be able to operate as an automated, peer-to-peer solution if it were not for the use of smart contracts.
- Advantages of decentralization
How you would rank the advantages of decentralization really depends on your view of what's most important. Having said that, the top three advantages are as follows:
- No Central Governance - Any changes necessary to keep the exchange functioning must be approved by the entire community.
- No Government Regulation - Because decentralized exchanges are not businesses and have no controlling entity or organization behind them, they are also free from government regulation. Like decentralized cryptocurrencies, the blockchain and ledgers that control decentralized exchanges are located on computer nodes around the world.
- Better Security - Decentralization, by its nature, increases security through multiple node hosting, cryptography, and proof of work algorithms. It is substantially more difficult to hack a decentralized exchange.
Like centralized exchanges, decentralized exchanges also have their disadvantages. They are by no means a perfect solution for buying and selling digital tokens.
- Disadvantages of Decentralization
A decentralized exchange tends to be more limited in terms of its function. There is no incentive within the community to continue building function, so these exchanges also tend to stagnate once they are established. For pure utility however, that is not necessarily a bad thing.
Three additional disadvantages of decentralization are as follows:
- Lower trade volumes
- Lower liquidity
- No fiat/crypto pairs.
The fact that decentralized exchanges do not offer fiat/crypto pairs means you can only buy and sell cryptocurrencies using other coins. You will not find any fiat being traded for crypto, or back again, on a decentralized exchange.
As hard as it might be to wrap your brain around this fact, there are hybrid exchanges as well. The hybrid exchange is owned and operated by a single organization or entity, but it still relies on many of the concepts of decentralization to maintain security and automate transactions. Creating a hybrid exchange provides the security of decentralization with the speed, volume, and liquidity of centralization.
It is worth pointing out that decentralization purists do not consider hybrids as hybrids at all. They tend to view them as centralized exchanges that just so happen to use some of the features of the blockchain technology to operate. They make a legitimate case when you consider the fact that the blockchain concept does not rely on decentralization and community ownership to function.
Choosing your exchange
Knowing that there are both centralized and decentralized exchanges leaves each crypto trader to decide for him/herself which model is the better of the two. In terms of practical application though, you are almost left with having to go to the centralized exchange to get started with cryptocurrency. Unless someone gifts you your first round of coins, you are going to have to buy them somewhere using fiat. That means the centralized exchange by default.
Also note that you may be limited in the coins you can buy and sell depending on the exchange you choose. If you are interested in trading some of the more obscure coins out there, you may have no choice but to go to a decentralized exchange. That would mean purchasing more widely accepted coins on a centralized exchange first, then using those coins on the decentralized exchange to buy the more obscure coins.
One last thing you should know about is asset security. Regardless of whether you use a centralized or decentralized exchange to make your trades, do not leave your assets under the control of the exchange. This is a disaster waiting to happen. Any exchange can be hacked if hackers have enough incentive to stick with it until they break in. Do not take that risk.
As soon as you're done with your trades, move your coins off the exchange and put them in cold storage. At least then your assets will not be exposed should your chosen exchange experience a security breach. If you don't understand what cold storage is, just run an internet search on the term. There is plenty of helpful information out there.