So many phrases are tossed around when it comes to cryptocurrency. Two important ones to understand include centralized and decentralized exchanges. A centralized exchange relies on intermediaries to oversee the transactions of users on its system. However, a decentralized exchange relies on technology.
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Similar Goals
Both systems are frequently used when it comes to digital assets and cryptocurrencies. More decentralized exchanges are popping up and growing in popularity, and centralized crypto exchanges have a long history, but at the end of the day, both share the same goal.
Whether centralized or decentralized, crypto exchanges all aim to facilitate users’ use of cryptocurrencies for all of their financial needs and services. How they go about that is what differs.
The systems also rely on the use of crypto wallets, which hold the “keys” of a user’s access. Both want to sell cryptocurrencies. But, which is doing it better? And who is in it for the long haul?
Decentralized Cryptocurrency Exchanges
One of the primary goals of decentralized exchanges is to remove the need for any third party. These exchanges are focused on allowing users to connect directly to one another.
In order to do so, decentralized exchanges rely on technology. In order to lower costs, cut processes, automate the exchange, and also maintain security and accuracy, the decentralized crypto exchange relies heavily on the world of tech.
Decentralized Exchanges Technology
At the core of decentralized financial systems (or DeFi) is the use of blockchain technology. These systems are typically unique to the specific cryptocurrency exchanged on its platform. They nearly always are nontransferable, meaning for example that a Bitcoin does not trade with Ether on the Ethereum. This presents a problem for some looking to buy, sell, and trade across systems.
However, the blockchain is a technology that allows for a shared, digital ledger to be copied to each user on a peer-to-peer network. Peers are able to connect to other users without a third party. Instead, blocks are created by miners containing data to record transactions.
The users of the blockchain agree to the system or set of rules, but there is no one individual with the power to oversee the process. This platform instead uses the peer-to-peer network, which typically operates in one of two manners: Proof of Work or Proof of Stake.
Proof of Work
Some blockchains rely on a proof of work model, which means that those wishing to “mine” the blocks must prove themselves via work. Miners will solve complex computations in order to show they have “worked” to get a new block. Actual electrical power, computational power, and human capacity all are provided by the miner.
Miners often charge gas fees to cover transactional costs, but overall, the power required, or the work put forth, is the way one participates in the decentralized ledger.
Proof of Stake
In a proof of stake model, the decentralized finance system operates as users post a stake or a sort of collateral. This pay-to-play model is more like a casino. Participants will post tokens at a chance to “win” a randomized chance to mine.
In this model, the DeFi apps focus on users posting money. If they are selected to mine, they “win” the chance to create a new block and reap the benefits.
Streamlined Process
Another major goal of the decentralized cryptocurrency exchange is to streamline the process of crypto. From buying and selling, to trading and creating, the DeFi system aims to use technology in order to make the process run more smoothly, eliminate human interactions and delays, and increase accuracy.
Smart Contracts
A big part of that streamlined technology is the smart contract. Smart contracts have been created to automate systems. They are “If/Then” programs, which allow that “if” X occurs, “then” Y can happen.
For example, an exchange may put into place a smart contract that states if 10 puzzles are solved by 10 p.m., the payment of 10 tokens may be released. The puzzles must be solved. The time must be met. If these things occur, then payment is made. Because it is programmed, it cuts immediately any errors inaccuracy.
In our example of 10s, it may be some easy math, but if that computation is happening hundreds of times a day, it certainly cuts down on the workflow if it is all just occurring via programming.
This eliminates the need for oversight and human interaction. Technology makes the workflow smoother, more efficient, and more effective. Fewer errors occur since a digital contract must have X to have Y occur. This streamlined and cost-effective method is very appealing to many.
No Central Authority
Being a main pillar of the crypto world, online users are attracted to the decentralized cryptocurrency exchange due to its independence. In this model, no one single authority has the right to change a block, remove a user, or set a rule. The entire exchange works as a unit, a team. Based on a peer-to-peer network, the group must adopt the overarching rules, but no single government nor bank oversees the system.
In more traditional bank models, there are major corporations, with many hands in the pot. This can increase the cost of doing business, but it also creates a hierarchy of power. At the end of the day, there is an authority who holds the decision-making ability.
The online world loves its anonymity. With no central figure overseeing, this can also remain a reality in a DeFi exchange.
Benefits of a Decentralized Exchange
Because DeFi operates with technology on its side, another basic pillar of its entire existence, there are some major pros included.
In short, the decentralization process is already a pro in and of itself for many. They appreciate the lack of a single authority, the exclusion of a third party, and the ability to connect directly to another user.
Typically, these decentralized cryptocurrency exchanges also allow for the fees and costs associated with those extra steps to be cut down or eliminated entirely. Where there are costs, such as the use of electricity, for example, miners are often footing that bill themselves.
Costs such as gas fees may be charged to the user, however, in order to cover, for example, a transaction fee.
Applications Using Decentralized Cryptocurrency Exchanges
Some examples of cryptocurrency platforms using DeFi exchanges include:
- Kyber
- Totle
- MakerDAO
Centralized Cryptocurrency Exchanges
In a centralized exchange, known sometimes as a CeFi system, the decision-making abilities are housed in the central “office.” While it does not matter how this central authority is physically stored, such as a central server or a brick-and-mortar office, it is the power that matters.
Think of centralized exchanges as requiring a hierarchy. A central authority is the boss of the land. They make the decisions, they oversee the products, they make the last calls.
In that system, others must adhere to the final say, the rules, the projections, the applications, the processes, nearly anything that the boss decides. A central bank (think of it as the HQ) tells its subsidiary locations (think your local bank and its tellers) how things will operate on the exchange.
From transaction fees to interest rates are decided by the “main office.” All involved must adhere to this authority.
Centralized Exchanges Technology
It is not as if centralized exchanges do not operate and rely on technology. After all, the entire crypto exchange concept is completely online. The centralized crypto exchanges provide some users with the comfort provided by an overseeing power. Where some prefer a peer-based public ledger, those operating on a centralized cryptocurrency exchange value the long history, the proven track record, and leaving the oversight to the pros.
A Central Authority
Centralized platforms are typically housed on centralized servers. This can put the cost of the operations back on the exchange. Where blockchains are typically operated via the power (literally and figuratively) of their users, a centralized authority also means centralized costs.
Centralized exchanges offer many benefits and are the chosen platform of a majority of the crypto exchanges. It is the longer-existing method, and has a far greater history, while DeFi remains in its infancy stages.
Centralized cryptocurrency exchanges depend on an intermediary to manage the transactions and activities of their users, and for some, that is a plus, while for others it is a minus.
Benefits of a Centralized Exchange
A major plus of the centralized finance system is that it supports cross-chain exchanges for multiple cryptocurrencies. Typically, these cryptos are generated on individual blockchains and work within an individual network. A Bitcoin isn’t traded from its DeFi app for an Ether on its Ethereum platform. These blockchains operate independently from one another.
But, in a centralized cryptocurrency exchange, users are enabled with the ability to access the conversion of digital and fiat currencies to cryptocurrency and vice-versa in an easy and seamless manner.
Applications Using a Centralized Exchange
Some examples of cryptocurrency platforms using the CeFi exchange include:
- Binance
- CoinBase
- Libra
Something Old, Something New
An Older, Centralized Exchange
While the entire concept of the cryptocurrency market is a rather new subject, centralized crypto exchanges are the more proven of the products. It is older. It has been around longer. And, with a vast majority of the exchanges operating under a centralized system, there is far more data to analyze.
Many find the centralized method to be closer to the traditional banking model, with the authority of the bank overseeing the processes. Many organizations have used it, and if they are going to buy and sell crypto, they’d prefer to have a qualified professional in charge of their investments (i.e. favor the centralized platform) and find that more reliability outweighs lower fees and peer-to-peer transactions.
A Newer, Decentralized Exchange
On the flip side, the new kid in town, a decentralized exchange, is certainly growing in popularity. While it may not have a proven track record just yet, there are vast improvements being shown as more and more crypto traders leave the centralized platforms in favor of enhanced privacy and closer relationships without intermediaries when making each transaction.
Beginner investors, or those with smaller financial involvement, may find comfort in a peer-focused environment that requires customers to have each other’s backs, and not a major bank, government, or institution at its core.
For Better or For Worse
Clearly, both centralized cryptocurrency exchanges and decentralized crypto exchanges have a plethora of pros and cons, some of which come down to personal preference. Centralized exchanges offer an intermediary, an authority, a professional voice. A decentralized cryptocurrency exchange can bring automation and technology to replace human complications and eliminate errors.
In Terms of Manipulation
It is certainly worth noting, to find an article helpful, that many concerns in the world of new, decentralized exchanges are fear of manipulation. Decentralized models are prone to market manipulation. With automated transactions and minimal gatekeeping, it is an environment almost begging to be hacked.
It doesn’t take much for a group of people and a handful of digital currencies to take over an entire blockchain. Without authority, some feel taking advantage of the system is inevitable. Preventing market manipulation needs to be a focused goal of the DeFi exchanges, and it needs to be quick and consistent.
What Does the Future Hold?
What does the future hold for cryptocurrencies and their exchanges? No one really can tell you that with 100 percent certainty. Investors will continue to watch the market. They will watch for changes in security. They will continue trading.
Users will “vote” with their investments to show how they are making financial decisions. Centralized vs. decentralized exchanges will continue to be a topic of discussion when it comes to crypto transactions, and likely many voices (both qualified and not) will weigh in with opinions.
There is not a single point at which we can consider one or another as “winning,” and thusly we are likely going to watch this “competition” for a long time to come.
