Though not many are familiar with concepts like centralization or centralized governance, in reality, you’ll be surprised by how many of the applications that you use every day are built upon such centralized networks. For instance, if you use social media, such as Facebook or Twitter, you’re actually using a centralized system. The same goes for YouTube, Gmail, Yahoo, and similar platform giants.
In comparison, decentralization refers to the transfer of the decision-making process and the control from a centralized entity, such as an organization, institution, or group of individuals, to a distributed network, where participants place their trust not in an institution or a middleman, but in coding and technology.
In this article, we’ll stick to centralization and decentralization in relation to the crypto market. In fact, we’ll start by explaining what cryptocurrency is and how it is decentralized before we move on to the mechanisms behind centralized and decentralized crypto exchanges.
Here we go!
What Is Cryptocurrency?
Cryptocurrency, or also known as digital or virtual currency, is a currency that is protected by cryptography. These digital currencies can be used as a medium of exchange and they enable you to partake in peer-to-peer transactions. Unlike fiat currencies, such as USD or EUR, cryptocurrencies aren’t managed by a central bank or another kind of central authority. Instead, every transaction that is made with cryptocurrency is recorded on a public ledger called blockchain.
Bitcoin was released in 2009, and it was the first digital currency that was built on a blockchain network. Since then, over 6,700 digital currencies (or altcoins) have been developed using blockchain technology, such as Ethereum, Litecoin, Monero, etc. All of these cryptocurrencies have an open-source code on their networks, meaning anyone can participate in building the next block on the blockchain, copy, or upgrade the system.
Is Blockchain Decentralized?
In order to explain whether blockchain is decentralized or not, we’ll take the case of how the blockchain is implemented by Bitcoin.
Similar to every database, Bitcoin needs lots of computers to store its blockchain data. The Bitcoin blockchain is like a particular kind of database that keeps records of all Bitcoin transactions. In this case, the computers that keep the network running are operated by individuals from all over the world instead of being controlled by a central authority. The computers that store Bitcoin’s blockchain are known as nodes.
Apart from storing the data, the nodes verify incoming transactions as well using complex algorithms. They try to find a mathematical solution, broadcast it to the network, and get approval to create the next block. This process is called the Proof of Work (PoW) consensus mechanism.
Having a peer-to-peer network that both stores and verifies transactions is what makes the blockchain decentralized. However, in the real world, there are also blockchains that are more centralized, i.e. orchestrated and owned by one entity. So, as you can see, not all blockchains are decentralized.
What Are Cryptocurrency Exchanges?
Cryptocurrency exchanges are platforms that you can use to trade (sell and buy) cryptocurrencies. They are also called digital currency exchanges (DCE). On these exchanges, you can trade one type of cryptocurrency for another. For example, you can convert Bitcoin to Ethereum, Litecoin to Bitcoin, or you can trade cryptocurrencies for fiat currencies (or vice versa), like Bitcoin for US dollars, or Euros for Ethereum. Cryptocurrency exchanges reflect the current market price of the digital currencies that they offer.
In fact, cryptocurrency exchanges are some kind of intermediary between the seller and the buyer, and these exchanges earn money from the transaction fees and commissions that they charge from the buyer and the seller. Unlike the fiat currency exchanges, the cryptocurrency exchanges work 24/7, i.e. they never close, and this is a big plus because you can trade your digital currencies whenever you want.
Today, the cryptocurrency market offers numerous cryptocurrency exchanges that you can choose from, such as Coinbase, Kraken, Binance, and LocalBitcoins (this exchange is specifically designed for trading Bitcoin), and they all offer different services. Here are some things that you might find helpful when searching for a suitable cryptocurrency exchange:
- Security – it’s good to choose a cryptocurrency exchange that offers high security for your assets, and includes features such as two-factor authentication. What this means is that besides your username and password, you’ll have to use an additional verification method in order to log in, such as entering a code that you’ll receive on your mobile phone or email.
- Fees – this is another thing that you have to take into consideration when you choose a crypto exchange, but you have to know that it isn’t always better to choose an exchange with lower fees because some exchanges might charge higher fees due to the higher security standard they have.
- Liquidity – when you are planning to sell, buy, or trade cryptocurrencies, you’ll want to choose a crypto exchange that has enough trading volume to make sure that your assets are quite liquid, or in other words, that you can trade the assets whenever you want.
- Coins offered – every crypto exchange offers some of the 6,700 digital currencies that exist, but not all of them. So, you have to choose the crypto exchange that offers the cryptocurrencies that you want to trade, buy, or sell.
Cryptocurrency exchanges can be divided into two main types: centralized and decentralized cryptocurrency exchanges.
What Is a Centralized Cryptocurrency Exchange?
Like all crypto exchanges, centralized cryptocurrency exchanges are platforms mainly designed to enable you to sell or buy digital currencies. In order to make a transaction, you have to trust the exchange who acts as a middleman. It monitors the transactions and keeps the assets secure on the behalf of the sellers and the buyers.
On centralized cryptocurrency exchanges, you have to provide your personal data and verify your identity, i.e. state your full name, address, utility bill, a government-issued ID, or even a bank statement, regardless of whether you’re signing up as an individual or a company.
If you want to have a higher quota for withdrawals, it’s better to provide as much personal/corporation data as you can, because in that case, the crypto exchange will raise your quota. Centralized exchanges offer 24/7 customer support, which is very helpful in cases when you somehow lose your password (private key) or have technical problems of any kind.
Advantages of Centralized Exchanges
- Liquidity – centralized cryptocurrency exchanges offer high liquidity at all times;
- Trading volume – if you want to place large volume orders, you cannot go wrong if you choose to trade your cryptocurrencies on centralized exchanges, as they provide high liquidity and sometimes have a separate OTC desk for larger orders;
- Speed – the transactions on centralized crypto exchanges are quite fast.
Disadvantages of Centralized Exchanges
It may sound ironic, but some factors that are considered advantages of centralized exchanges can also be seen their disadvantages:
- Recovery possibility – centralized crypto exchanges hold your private key, so in case you lose it, you can recover it with the method that the exchange offers you. You can consider this to be an advantage, but by entrusting your private key to the exchange, you won’t have full control over your assets.
- Security – centralized crypto exchanges provide liquidity at all times because they keep a portion of the assets online for immediate trading/withdrawals. However, due to this, centralized crypto exchanges very often are targeted by malicious actors, meaning they are often attacked by hackers. Think of what happened to Mt. Gox.
- Transaction fees – centralized crypto exchanges are known for charging high transaction fees for their convenience and services, and these fees can get quite high when it comes to trading a large number of assets.
What Is a Decentralized Cryptocurrency Exchange?
The second kind of cryptocurrency exchange is the decentralized one, or DEX. These platforms appeared as an alternative to centralized exchanges in order to avoid the middleman, creating a “trustless” ecosystem. These decentralized platforms enable you to make peer-to-peer transactions with no third parties acting as middlemen, and the transactions are made entirely based on atomic swaps or smart contracts.
We have to point out that decentralized crypto exchanges don’t support crypto to fiat trading pairs yet. For example, you can’t trade USD for BTC, or EUR/ETH. Here are some popular decentralized crypto exchanges that you can use: AirSwap, Idex, and Kyber Network.
So, how does a decentralized exchange work?
- First, you have to place an order if you want to trade your cryptocurrency for another one that the chosen DEX supports. You specify the amount of digital currency that you want to trade, the price of the asset, and the time for bidding.
- Next, the interested users can place their bids by signaling the trade order.
- After the expiry of the time that you set, all the bids will be reviewed, and you can do the trading with the bid that you think is good enough.
- You use your crypto wallet address to sign into a decentralized exchange;
- Next, you select a sell or buy request;
- Then a smart contract is made and the transfer of the cryptocurrency is done;
- And at the end, you can log out.
Advantages of Decentralized Exchanges
- Security – due to the fact that decentralized cryptocurrency exchanges don’t store your funds, the risk of hacking is minimized.
- Anonymity – decentralized crypto exchanges don’t require you to complete a Know-Your-Customer (KYC) check, meaning they don’t ask you to give them your personal data and due to this they offer you a higher level of privacy and anonymity.
- Lower transaction fees – the average transaction fee of a decentralized crypto exchange is 0.165%, which is around 50% lower than the transaction fees of a centralized cryptocurrency exchange. So, in general, decentralized crypto exchanges have lower fees than centralized ones.
- Custody – unlike using centralized crypto exchange, when using a decentralized one, the control of the private key remains in your hands only.
Disadvantages of Decentralized Exchanges
- Complexity – if you decide to use a decentralized crypto exchange, you’ll have to remember your private keys and passwords, otherwise your assets will be lost forever because these crypto exchanges don’t have recovery options. Another thing is that decentralized platforms have a steep learning curve, so it might take some time for beginners to get the hang of it.
- Lack of fiat payments – due to the fact that decentralized crypto exchanges don’t support crypto to fiat trading, you’ll need to use another platform to purchase digital currencies first which might be inconvenient.
- Lack of liquidity – decentralized crypto exchanges have lower trading volumes, which often leads to a lack of liquidity. Moreover, if the trading volume is low, the process of finding sellers and buyers can be quite the bumpy journey.
Centralized vs Decentralized Exchanges
In this heading, we will explain some of the main differences between centralized and decentralized cryptocurrency exchanges, so here we go:
In a decentralized crypto exchange, the control of your account is in your hands. But with a centralized cryptocurrency exchange, the complete opposite is true, meaning almost all control of your account is in the hands of the crypto exchange.
Many believe that by using a decentralized cryptocurrency exchange, your assets will be more secure than if you choose to use a centralized cryptocurrency exchange. And really, if you trade on a centralized cryptocurrency exchange, the possibility of hacker attacks is more likely, due to the fact that the bad actors want to get their hands on your private key in order to gain access to your assets.
Conversely, there is a lower risk if you choose to use decentralized platforms because the chance of users losing their assets is close to zero unless the attack is related to the gates of the decentralized exchange. On the other hand, the responsibility to keep your private key safe falls on you.
When it comes to features, centralized cryptocurrency exchanges have an advantage over decentralized ones, because they offer you portfolio management tools, margin trading, and several advanced order methods for better trading. Plus, you get to trade fiat for crypto, which you may wish to have as an option. Unlike centralized exchanges, decentralized exchanges offer you a limited number of orders, and most of them don’t support margin trading.
Decentralized cryptocurrency exchanges are more difficult to regulate than centralized ones. Centralized cryptocurrency exchanges need to have licenses in order to operate under different jurisdictions and they need to stick to the regulations of the central authority (government) of their location. Unlike them, DEXs often go under the radar by classifying themselves as decentralized protocols with their own blockchain-based governance.
A Few Words Before You Go…
Hopefully, in this article we’ve helped you understand the difference between a centralized and decentralized cryptocurrency exchange, their advantages and disadvantages, as well as what these two terms mean in a broader crypto context. Now you have a clear picture of the types of market governance and you can easily decide what sort of platform will suit your needs best.