Decentralized Exchanges And Centralized Exchanges: What Are The Differences?

An image representing centralization and decentralization.

There are two main types of cryptocurrency exchanges: decentralized exchanges and centralized exchanges. There are a few important differences between these two types and most cryptocurrency investors have a preference for one or the other. However, it is possible to be a trader who sometimes trades cryptocurrencies using decentralized exchanges and other times trades using centralized exchanges. In other words, you aren’t limited to using just one type of exchange.

They both have different advantages, and in order to determine which you would like to use for a particular trade, it’s important to understand the advantages and potential drawbacks of each one.

Centralized Exchanges

The concept of centralization that is present in centralized exchanges refers to the fact that centralized exchanges use a third party to help complete transactions. This means that both the buyer and the seller in a transaction have to trust the third party to handle their assets.

This is similar to how a customer trusts a bank to hold their money for them, although instead of a bank holding a customer’s fiat currency for them and helping them with transactions, a centralized exchange has custody over a trader’s digital assets, helping them store their assets, and assists them with completing transactions.

Benefits Of Centralized Exchanges

Due to the fact that centralized exchanges have some custody of their customers’ digital assets, centralized exchanges are considered custodial. Since centralized exchanges help traders with completing transactions, they are generally considered to be easier to use than decentralized exchanges. Often this means that centralized exchanges are the go-to exchange type for new crypto traders and investors, and many people, both new to cryptocurrency trading and experienced at it, prefer to use them.

Particularly people who prefer their trading experience to be simple use centralized exchanges and are willing to overlook the fact that they are required to trust the exchange itself in order to complete transactions through an easy-to-use, hassle-free platform. Although for many people these benefits are enough to make them think twice about switching their preference to decentralized exchanges, centralized exchanges do have some drawbacks.

Disadvantages Of Centralized Exchanges

One disadvantage of centralized exchanges is that their more centralized functioning makes them more vulnerable to fund loss and theft. If you are wondering why that is, consider what you would choose if you were going to try to rob an exchange. Wouldn’t you prefer all of the money to be kept centralized in one place by a centralized authority, where you could gain access to all of it through hacking one location? Decentralized exchanges don’t have custody of their clients’ funds directly, making a hacking attempt less likely and less appealing to potential hackers and robbers. Centralized exchanges store most transactions on their servers, making them particularly attractive to criminals.

Centralized exchanges also have a liquidity problem, and often struggle to fulfill large orders. They also have a relatively high degree of risk for users since users must rely on centralized exchanges to be able to prevent potential performance issues, hardware failures, and other problems that can arise when dealing with large trading volumes.

Another disadvantage of centralized exchanges is that they are centralized platforms operating in an industry that was built on recognizing and promoting the advantages of decentralization. They also often require KYC procedures to be completed, making them inaccessible to people who do not have the documentation required to complete these requirements.

Examples of Centralized Exchanges

Some of the most well-known centralized exchanges that have the largest trading volumes are:

Decentralized Exchanges

Unlike centralized exchanges, decentralized exchanges don’t require a centralized authority to be involved in the transaction process. In decentralized exchanges, there is no single point of failure. This means they don’t have the same disadvantages that centralized exchanges have.

Benefits Of Decentralized Exchanges

The main benefits of decentralized exchanges is that they are fully transparent and the technology powering the smart contracts used in decentralized exchanges is open source. Decentralized exchanges enable peer-to-peer trading. Automated smart contracts are used to complete trades without the need for an intermediary. Users of decentralized exchanges remain in full custody of their digital assets. For this reason, they are considered to be non-custodial.

Due to the use of smart contracts and the lack of intermediaries in trades, trades are virtually instant and transactions are usually less expensive than on centralized exchanges. Decentralized exchanges also allow users to hold their private keys. They also have the added benefit of being decentralized, which to many cryptocurrency investors is enough of a benefit that they are willing to complete a few extra steps and overlook the convenience associated with centralized exchanges. For these reasons, decentralized exchanges are growing in popularity.

The first decentralized exchanges used order books like centralized exchanges. The order books include all buy and sell orders that are open for each asset available for trading. The newer decentralized exchanges don’t use order books. They usually use liquidity pool pricing to determine the pricing of particular assets. These particular exchanges complete trades between users’ wallets instantly through a process known as a “swap”.

The Main Disadvantage Of Decentralized Exchanges

The main disadvantage of decentralized exchanges is that they are more complicated than centralized exchanges and are not as easy for new cryptocurrency investors to use. For this reason, some new cryptocurrency investors and other investors who prefer simple trading processes opt not to use them. Due to the fact that the exchanges themselves don’t help users complete trades, they have to complete the steps of the trading process themselves and remember their keys.

Examples Of Decentralized Exchanges

Some of the most well-known decentralized exchanges are:

Will Centralized Exchanges Continue To Exist?

Considering the disadvantages associated with the existence of centralized exchanges within an industry that emphasizes decentralization, some people have indicated that they believe centralized exchanges will become obsolete at some point. However, it seems unrealistic to believe that this will happen unless the next generation of decentralized exchanges is much easier to use.

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