Decentralized Exchanges Vs. Centralized Exchanges
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.
Centralized exchanges (like Binance, Coinbase, and Kraken) function by utilizing intermediaries, typically companies, to facilitate trading activities on their platforms. These intermediaries act as middlemen and charge trading fees for their services. This setup makes centralized exchanges the go-to choice for newcomers interested in cryptocurrency trading, as they provide a user-friendly interface connecting individuals to both cryptocurrency markets and the real economy.
The operation of a centralized exchange is fairly simple. Let's take Bob as an example. If Bob wants to purchase 5 Bitcoins, there are two possible scenarios. Firstly, Bob can browse the order book and find an existing offer that meets his requirements. Usually, a matching algorithm automates this process. If Bob agrees to buy 5 Bitcoins at the specified asking price, his buy order will be automatically matched with a corresponding sell order that fulfills his criteria. Alternatively, Bob has the option to create his own buy order, giving him control over the trade's terms, such as price and quantity.
In contrast to centralized exchanges, decentralized exchanges (like Uniswap and PancakeSwap) between operate without intermediaries. Instead of matching buy and sell orders in an order book, decentralized exchanges directly match individuals behind those orders.
For instance, if Bob wants to buy 5 Bitcoins, he will be directly connected with Alice, who intends to sell the same amount. They can negotiate a mutually agreeable price and execute the trade. This entire process is facilitated by preprogrammed matching exchange software, eliminating the need for intermediaries.
The architecture of a decentralized exchange offers significant advantages. Firstly, trading fees are almost negligible since there is no intermediary involved. Additionally, decentralized exchanges prioritize privacy. Unlike centralized exchanges that often require personal information and identity verification, decentralized exchanges only require disclosure of identity to the specific individual you are trading with. Security is also enhanced as decentralized exchanges don't hold users' cryptocurrency; instead, users directly transact with each other, mitigating concerns about the security of funds held on an exchange.
Difference in Popularity and Use
Despite these advantages, decentralized exchanges have not gained the same level of prominence as centralized ones. This can present challenges when trading on existing decentralized platforms. Due to their smaller user base, decentralized exchanges experience lower trading volumes compared to centralized counterparts. Consequently, finding suitable trades can be more difficult, and liquidity is impacted as it becomes harder to sell cryptocurrency and convert it into cash.
Moreover, decentralized exchanges often have longer trade times since traders have to wait for cryptocurrency and fiat transactions to complete before finalizing a trade. This makes it challenging for traders who rely on fast trade execution to capitalize on market movements.
Lastly, decentralized exchanges currently lack advanced trading functionalities like margin trading and stop losses, which further limits their appeal for traders seeking a comprehensive trading experience.
The philosophy of decentralization and its associated benefits have been foundational to the blockchain and cryptocurrency industry. Surprisingly, this philosophy hasn't fully translated to how most users engage in trading within the space. Centralized exchanges still overshadow decentralized counterparts, primarily due to the superior trading functionalities they currently offer. However, as decentralized exchanges continue to evolve and improve, it's possible that we will witness a shift in preference towards the more decentralized model.