Cryptocurrencies and decentralized technologies are booming. The numbers speak for themselves — market capitalizations have gone through the roof, transaction volume has skyrocketed, and adoption from individuals, corporations, and governments has reached a global scale.
Thanks to blockchain technology, we are moving toward a trustless economy, with no need for third parties to exchange goods. Yet today’s digital currency exchanges are centralized. They have proven to be vulnerable to hacks, react poorly to unusual blockchain events like hard forks, and often run with a high regulatory risk. Centralized exchanges keep their systems off-chain, meaning they operate as escrows for their clients, and transactions are not recorded on the blockchain. This leads to massive breaches of security and unsafe storage of information, funds, and private keys.
Trading comes with risks, but traders should not face any other risks than those they are already willing to take.
Blockchain entrepreneurs understand this, and some of them are working hard on what many believe will be the future of trading: decentralized exchanges.
Decentralized exchanges — or DEXes — aim to tackle the problems that impede centralized structures by building peer-to-peer marketplaces directly on the blockchain — Ethereum mostly — allowing traders to remain custodians of their funds. However, building a fully decentralized and efficient exchange remains today something of a utopia. Exchanges are centralized because it is the simplest way to proceed, and it is either too costly or technically complex to build fully decentralized platforms — for now, at least.
Throwbacks and inefficiencies of centralized exchanges leave the model with only a few advantages. Many semi-decentralized exchanges are coming into action. They are hybrid models between centralized and decentralized marketplaces, trying to deliver the best of both worlds. There is an increasing number of such exchanges, following up on a need expressed by the crypto-community.
Centralized Exchanges
Let’s first define what centralized exchanges are: platforms and apps that enable traders to buy, sell and exchange cryptocurrencies against fiat currencies or other cryptocurrencies. They are marketplaces for tokens and are essential to the ecosystem since many of them enable payments with fiat currencies, i.e. non-crypto holders are able to buy crypto using USD, EUR, etc.
Among the most well-known and trafficked centralized exchanges are Bithumb, Bitfinex, Bittrex, Belpay, Poloniex, and Kraken. Hundreds already exist, but the goal here is not to focus on their number, but rather on their limitations and potential for improvement.
Centralized cryptocurrency exchanges may soon become obsolete as they lose the opportunity to leverage blockchain technology to improve their capabilities and efficiency.
- Insecurity, risk of fund loss and thefts due to their centralized functioning. They are legally accountable and a custodian of users’ funds. 73% of centralized exchanges take custody of user funds, while 23% let users control keys⁴. They represent honeypots for hackers as they are responsible for billions of trades per day and store most of them on their servers.
- A lack of liquidity: large orders struggle to be matched. Even at an all-time high, volumes remain low (compared to traditional markets).
- A fragmented (not to say decentralized) market: divides the global liquidity into a few main marketplaces. No clear market leader in terms of volume, which increases the liquidity problem.
- A high level of risks for users due to potential performance issues, market manipulation, hardware failures, latency problems, and many other inherent problems when it comes to dealing with large volumes…
- A lack of trust and transparency: actual costs and processes of trading are opaque and involve high trading costs, often higher than announced fees and higher delays due to peaks of demand badly managed. Plus, they can front-run orders, which is illegal.
- A lack of educated users: markets are flooded by pure speculators unaware of safe ways to deal with cryptocurrencies.
Conclusion
99% of cryptocurrency transactions still go through centralized exchanges; this trend is expected to be reversed in the coming years. Switching to decentralized exchanges is necessary for cryptocurrency users to exploit their full potential, aligning with the decentralized nature of the blockchain itself. Education is arriving, and most technological hurdles we face today will probably be overcome very soon.
Centralized exchanges will shift toward decentralized technologies sooner rather than later, but improvements have to come from both sides. Users to learn how to protect themselves, and platforms must provide better security tools, as well as education around common issues and best practices.
