A cryptocurrency exchange is a gateway for its users to perform crypto to crypto and fiat to crypto trading. Most popular cryptocurrency exchanges today are centralized. This is because roughly 99.8% of crypto trades happen in centralized exchanges as users prefer centralized exchanges over decentralized exchanges. Even though there have been instances of notorious hacks in the past (for example, the infamous Mt. Gox hack), centralized exchanges still dominate the crypto-space by a long shot, though the number of hacks has only continued to increase. Does this mean that traders and investors are willing to sacrifice security for liquidity? Why are decentralized exchanges that resonate with the spirit of the decentralized blockchain economy NOT preferred by users? Let’s take a look.
Centralized Exchanges (CEXs)
CEXs are usually run and monitored by a team of dedicated professionals who act as administrators of the exchange. Due to the nature of their operation, most CEXs require you to verify KYC in order to be compliant with AML (Anti-Money Laundering) and CFT (Counter-Terrorist Financing) laws. Recent regulations enforced by the FATF (Financial Action Task Force) has rendered it imperative for crypto exchanges to obtain users’ personal information. The enforcement of the crypto travel rule and the crackdown on exchanges to share sender and recipient data for inter-exchange and intra-exchange trades is considered to be a measure against illicit and unwarranted usage of cryptocurrencies. However, this is a blow to the head for the crypto and blockchain world. Blockchains are intended to act as a transparent, immutable, decentralized and distributed ledger that stores time-stamped data, does not necessarily require a governing body and can function autonomously. CEXs remove the decentralized aspect from blockchains, akin to removing the flesh from bone. CEXs are trust-based systems and you have to trust them to complete your trade. Users do not have access to their private keys.
But one cannot ignore the advantages that CEXs do offer. CEXs use the order book model, so your buy or sell order is automatically matched with the corresponding sell or buy order in the order book. Orders are matched instantly as the market depth in a CEX is higher than that of a DEX. Similar to conventional stock exchanges, a fee is collected for the trades that you execute on a CEX. Most centralized crypto trading platforms are insured against loss due to hacks and technical failures.
Blunders happen ever so often. If you forget your password, your password is stolen, you’re unable to access your account or if something seems amiss, you can always turn to their customer support for help. Another major advantage of a CEX is buying cryptocurrencies with fiat currency through bank wire transfers, credit cards, debit cards, and online payment platforms. The scale at which a CEX operates attracts whales and institutional investors.
👉 The liquidity of centralized exchanges: Liquidity is underpinned by the number of traders using the crypto trading platform and an abundance of crypto reserves. An asset or market pair’s liquidity is essential for orders to be matched as soon as they are placed. Lower liquidity means that the difference between the highest bid and the lowest ask in the market is less, that is, the market is not as volatile. Centralized exchanges boast high liquidity of assets and their markets have a tight spread resulting in instantaneous trade execution.
👉 The latency of centralized exchanges: For traders, the minuscule amount of time that is required to process market information is often the margin between a profit and a loss. This is especially true in the case of high-frequency algorithmic trading and derivatives trading. It may not be much of a concern for investors who invest over the long term. But it is vital for traders. Every year, institutional traders spend huge sums just to stay one step ahead of the competition. That is why low latency is a highly sought after feature in a cryptocurrency exchange.
CEXs generally have low latency in the order of milliseconds or microseconds. Ultra-low latency (lower relay-times and fast order execution) is determinant in maintaining a high order-to-trade ratio. When a substantial risk is involved, as in derivatives trade, the trader always looks for an exchange that has the lowest latency.
👉 The security of centralized exchanges: Many CEXs employ sophisticated techniques so as to secure their user funds and as a precaution against hackers. But this has only insinuated hackers to commission similar sophisticated methods (such as a well-organized phishing or dusting attack) to break into their security. Centralized exchanges have lost user funds and data to malicious actors over and over again. They have also been the subject of insider hacks.
Decentralized Exchanges (DEXs)
A decentralized cryptocurrency exchange (DEX) is operated by a smart contract or a protocol. They are trustless systems in which the user assets are not controlled by a central authority but rather by the smart contract which receives, collates, and matches orders. Some DEXs are community governed. But do decentralized exchanges collect fees? Yes, they do. DEXs collect fee that is required to operate the exchange and this fee is distributed to the staking/service nodes that run the protocol.
DEXs do not mandate you to provide your personal information – read: no KYC verification. Users trade peer-to-peer, anonymously. Since trading is peer-to-peer, DEXs essentially match sellers with buyers. Users are responsible for their funds. Funds stored in a user’s wallet are protected by a Private Key and only the holder of this key can access the wallet. DEXs are not bound by rules and regulations and thus are free from the clutches of any governmental or law enforcement organization.
Though DEXs embody the vision of the decentralized blockchain economy, they have certain drawbacks that need to be addressed. Firstly, they do not support crypto-to-fiat trading. Though some DEXs claim to provide this feature, it is paradoxical. Fiat currencies are connected to your bank accounts, subsequently, your real-world identities and any DEX that supports the buying of crypto with fiat undermines the purpose of decentralization. No customer support or central authority means there can be no effective mediator to act as an arbitrator in case of a disputed transaction. DEXs are also not insured against losses.
The scalability of a DEX depends on the blockchain platform that supports it. Moreover, DEXs can only support tokens native to their platform. An Etherum based DEX will support the trading of ERC-20 tokens while a DEX based on the Bitcoin core protocol will support Bitcoin and its forks. This makes trading between cryptocurrencies such as BTC/ETH a cross-chain or inter-chain process.
To facilitate cross-platform trading, decentralized exchanges use proxy tokens, atomic swaps and cross chain bridges. But these technologies are in the rudimentary stages. Furthermore, not all DEXs are completely decentralized. Certain DEXs only decentralized the swapping of coins/tokens – exchange occurs on chain while orders are matched off chain. These partially decentralized DEXs are still dependant on a third party to maintain their order books.
👉 The liquidity of decentralized exchanges: Liquidity is scarce in a DEX. Many decentralized exchanges are either partnering with centralized ones, introducing airdrop schemes to act as catalysts for liquidity generation or simply shutting down operations. Liquidity in a DEX is usually community-driven and if a coin/token does not have a solid community backing it up, it will result in illiquid markets and price fluctuation.
👉 The latency of decentralized exchanges: The latency of information transmitted is high in a DEX. The Bitcoin blockchain alone takes about 10 minutes to transmit transactional data and a DEX developed based on the Bitcoin protocol will suffer a similar fate. High-frequency trading is not possible in a DEX at the moment. Cross-chain trading only adds to the congestion.
👉 The security of decentralized exchanges: A DEX should ideally be resistant to hacks. The capital investment and complexity needed to break through a decentralized system is enough to discourage a hacker. But DEXs are only as secure as their smart contracts. Exchanges that were perceived to be decentralized have been hacked in the past due to flaws in their smart contracts. Furthermore, when two blockchains are bridged to allow trading between non-native tokens, the security of the resulting chain is dependant on the parent chains.
Recently, a number of decentralized exchanges have shut down owing to difficulties in operation, regulatory pressure and unfavorable market conditions. Some have even rebranded as a Hybrid exchange.
Beldex is and has always been a Hybrid Crypto Exchange (HEX) since its inception. It is designed to overcome the shortcomings of a centralized and decentralized exchange while allowing users to retain control over their accounts. Registrations to our hybrid Shariah-compliant exchange is open and trading will commence soon.