Decentralized Exchanges Vs. Centralized Exchanges
Last Updated: 1st November 2018
Decentralization is the very process of distributing decision making powers from central authority. One of the more attractive features of cryptocurrency is that it cannot be controlled by any central entity. On peer-to-peer systems such as the Bitcoin network, the transfer of value does not require the involvement of central authority, because transactions are validated by a distributed group of miners that exist on the network. However, this same idea of decentralization that exists with cryptocurrency has not fully materialized with regard to cryptocurrency exchanges. An overwhelming majority of trades in the cryptocurrency space are made on centralized exchanges, as opposed to decentralized exchanges.
With centralized exchanges, intermediaries such as companies act as middle men in order to facilitate trading on their platform. In exchange for providing this service, intermediaries collect trading fees. In essence, centralized exchanges often act as the first point of contact for newcomers that are interested in trading cryptocurrency. Many individuals seek to have an interface that can connect them to both cryptocurrency trading and the real economy, and centralized exchanges provide that.
The operation of a centralized exchange is straightforward. If Bob wants to buy 5 Bitcoins, one of two scenarios can occur. Bob can go to the order book and find an offer that he is willing to accept. Normally, a matching algorithm automates this process, and if Bob is willing to buy 5 Bitcoins at the set asking price, then Bob’s buy order will automatically be matched with a corresponding sell order that fulfil his requirements. Bob could also create his own buy order, this allows him to set the terms of the trade, specifying terms such as price and quantity.
Unlike centralized exchanges, their decentralized counterparts do not require intermediaries for their operation. Instead of matching buy orders and sell orders in an order book, a decentralized exchange operates by matching the people behind those buy and sell orders. For example, if Bob wanted to purchase 5 Bitcoins, he would be directly matched with Alice, who also wants to sell 5 Bitcoins. From there, Bob and Alice can agree to a price and finalize their trade. A preprogramed matching exchange software facilitates this entire process, so, there is no need for any intermediary involvement.
The architecture of decentralized exchanges means that there are significant advantages to using them. For example, the absence of an intermediary allows for almost non-existent trading fees. Decentralized exchanges are also more private, centralized exchanges often require personal information and proof of identity e.g. passport, in order to trade on their platform. A decentralized exchange does not require any disclosure of identity, with a disclosure of identity only being required to the individual that you are conducting the trade with. Lastly, the issue of security is also improved under the decentralized exchange model. Decentralized exchanges do not hold cryptocurrency for users, and instead, users are connected directly with each other, meaning that you do not have to worry about the security of your cryptocurrency sitting on an exchange.
Despite its many advantages, the use of decentralized exchanges is simply not as prominent as their centralized counterparts. This can make trading on existing decentralized platforms an issue. Due to the smaller audience on decentralized exchanges, they have much lower trading volumes than centralized ones. This means that finding an acceptable trade can be a difficult process. It also impacts liquidity; lower trading volume makes it harder to sell cryptocurrency and liquidate into cash. Decentralized exchanges also suffer from longer trade times, traders have to wait for cryptocurrency and fiat transactions to complete before a trade can be finalized. Thus, traders that require fast trade times to capitalize on market movements will find it difficult to do so on a decentralized exchange. Lastly, decentralized exchanges currently do not offer advanced trading functionalities such as margin trading and stop losses, making the case more difficult for traders to utilize the decentralized platform.
The blockchain and cryptocurrency space have been built on a philosophy of decentralization and the advantages that it brings. However, this same philosophy has not carried over to how the majority of users are conducting trades within the space. Decentralized exchanges continue to be overlooked for their centralized counterparts, that do currently offer significantly better trading functionalities. However, as the development of decentralized exchanges progresses, it may be likely that we see a shift in preference to the more decentralized model.