Future challenges: centralized exchanges vs decentralized
The active development of the cryptocurrency industry led the world into a new era of digital mutual settlements. The main factors that made it popular were anonymity and decentralization. However, the same factors have led to an ambiguous reaction of the government of the largest countries that do not want to release key financial flows from their hands.
Investments in digital money and the number of transactions conducted with them by crypto-exchange exchanges are increasing. The principle of earning is quite simple: buy btc, bitcoin gold, ethereum or other promising currency; wait until it grows in price; sell and make a profit.
There are several important reasons that prevent a massive influx of customers into this activity field – high volatility and distrust of major players in the financial market. As a result, the desire to quickly get rich can lead to privations because of the risk of missing the moment of a sharp fall in the value of the chosen currency by trading on one of the functioning crypto-exchanges, and the correct choice of the platform, in this case, plays a key role.
Thanks to the blockchain technology, we are moving to an economy that does not require the trust of third parties for the goods exchange. However, today’s crypto exchanges are centralized: they are vulnerable to hacking, they do not react well to the processes associated with blockchain (for example, hard-forks) and are often associated with the risk of regulation by governments. The systems of centralized exchanges are outside the blockchain, and it means that exchanges work as organizations that carry out the escrow of their clients’ money; while transactions are not recorded in the blockchain. This, in fact, a massive security breach: unsafe storage of information, money and private keys.
Centralized crypto-exchanges are convenient for use, but they are in fact insecure. Such precedents as hacking Mt. Gox, Youbit, Bitfinex are no longer news, users pay for their ephemeral convenience with their assets. Only in the past 1.5 years, hackers managed to steal more than $ 1.2 billion in cryptocurrencies. The total amount of losses exceeded $ 1 billion. Trading platforms are reluctant to acknowledge the theft of funds, as this negatively affects the reputation. And the cryptocurrency market reacts on reports about theft by a sharp drop. But over time, investors once again became bolder, so the funds returned to the market, and trade continued with an even greater scope. Site owners updated security systems and implemented fundamentally new methods of storing funds, for example, the withdrawal of non-operational capital into cold stores or to hardware wallets.
Thanks to centralized exchanges, traders can exchange or sell any kind of fiat money for cryptocurrency. Such exchanges are also needed for the sale of tokens and the functioning of the cryptosystem as a whole. The most famous and visited centralized exchanges are Bithumb, Bitfinex, Bittrex, Poloniex, Kraken, GDAX, Coinbase, Gemini.
How it works and why this risky?
Centralized crypto-exchange has a trusted intermediary, which participates in the transfer of funds of individuals or institutions to each other. The role of the exchange is to eliminate the contradictions associated with the exchange, by providing liquidity (market liquidity implies how much the stock or real estate market allows you to buy and sell assets at a stable price) and convenience through the account where the assets and funds are stored. This means that since the start of the use of any centralized exchange it becomes the custodian of our funds, and we are no longer responsible for our assets ourselves. Some inexperienced users use centralized exchanges that do not allow users to manage private keys for their cryptocurrency, instead of companies store their keys on a centralized server or in a database.
Here hides the main drawback of all centralized exchanges: they are easy to hack. At the very beginning of trading, the client transfers all the money to the intermediary and no one can guarantee safety. There are no centralized systems that can guarantee 100% protection against hacking. 73% of the sites are solely responsible for storing users’ funds, and 23% allow customers to manage keys. The exchanges are a tasty morsel for hackers, given that billions of transactions are made through them every day and servers store user money.
In addition, centralized exchanges combine the trade volume, information about customer accounts, funds and positions. While this is convenient for users who can log in to their account via e-mail and password, it also means that exchanges become an attractive target for hackers who can steal funds or personal information of account holders.
Since the centralized exchange functions as a standard business with a physical location and registration authority, it may be closed or otherwise subjected to censorship by governments intervention.
We can also note such disadvantages as a lack of liquidity when large exchange orders cant always be executed, a fragmented market, a high level of risks for users due to performance problems, market manipulation, equipment failures, delayed payment problems, lack of trust and transparency, transaction delays, lack of qualified users…
Decentralized markets are a new challenge. Since there is no central representative, owner, provider – there is no way to close the entire system. Because the trade is peer-to-peer, the only way to stop trading is to stop every person involved in illegal activities from taking out all software or disrupting communication between them. This is a potentially long process.
Fortunately, decentralized markets cant be very attractive to criminal activity. Some of the leading decentralized markets do not use anonymity methods to hide the IP addresses of their users, which means that any activity on the network can be easily controlled by law enforcement. In addition, when using a centralized market, the offender lays the responsibility on the site operator. In a decentralized market, each user independently runs his own store / conducts transactions on the exchange of cryptocurrencies and must take care of his privacy and security.
DEX, in contrast to the centralized, is built on a blockchain. They don’t store funds or information about customers but serves only to match and route trade orders. However, most decentralized exchanges are in fact decentralized to only half. Complete decentralization today is a difficult task (the reasons for this will be listed below). While some centralized servers store, for example, order tables, but do not store private keys. And it is worth considering.
The main advantages of a decentralized crypto-exchange are:
– Conformity the basic principle of a decentralized currency, because it makes no sense to use a decentralized currency or asset in a centralized environment. The centralization of the exchange is contrary to the goals of using cryptocurrency.
– Expede the implementation of cryptographic solutions and allow cryptocurrencies to flourish.
– They denounce censorship or control over national governments or any group of companies.
– Providing full control in the matter of owning their own currency.
– Respecting the privacy of users and avoid the needs of registration.
– They do not have idle time, as assets are distributed among users.
– Providing seamless liquidity for many crypto-currencies. Including for those assets that can not be listed on centralized exchanges during the ICO.
Despite the fact that decentralized exchanges are anonymous, free from censorship and security, there are many practical tasks that they need to solve before they can again compete with centralized exchanges.
Some of the weaknesses faced by decentralized crypto-exchanges:
-The lack of users. They prefer centralized services because of the convenience, and many users are willing to sacrifice such privileges as confidentiality, security, and freedom.
– For the moment they are not as user-friendly as centralized exchanges.
– Due to a lack of volume, liquidity problems may arise.
– There are no extended trading functions, such as margin trading, margin lending, stop-loss trading with trading robots.
– Most of the decentralized exchanges are now at the beta stage, and users are at risk of losing their funds due to errors in their work.
Decentralized exchanges have a good future, but unfortunately, at the moment, they can not compete with centralized ones, as they do not have such a wide range of functions. However, it is interesting how they will develop and what impact they will have on the cryptosystem as a whole. At the moment, almost all financial transactions are carried out on the basis of centralized exchanges, but the development of decentralization is necessary, as it will expand the circle of users, increase their confidence in cryptocurrencies, and present experience in the cryptocurrency market.
And as Vitalik Buterin said: «I definitely hope centralized exchanges go burn in hell as much as possible».