Centralized vs. Decentralized Exchanges - The Basics

With the development of blockchain technology, cryptocurrency is changing the way we think about any kind of exchange. Even so, cryptocurrency exchanges can happen in one of two ways. There are centralized and decentralized options.

While many may see any kind of cryptocurrency exchange as a step beyond how we normally view commerce, there’s still nuances you must understand if you want to ensure you’re getting the most out of your transaction. That’s where the fundamental difference between centralized and decentralized exchanges comes into play. Here are the most important factors you need to know to understand the difference and why decentralized exchanges might be the better option.

Philosophy of Blockchain

Blockchain is the revolutionary technology that allows cryptocurrency as we know it today to exist. In general, the motivation behind any new piece of technology is profit, as shown with the latest smartphones and other gadgets, but blockchain was created as an alternative form of monetary exchange that puts control in the hands of the people. The entire platform was created to be community oriented with open-source accessibility.

While there are certain development teams and authority figures within the realm of blockchain, they still frequently abide by the will of the people and allow people to have the vast majority of control over general operations. Loosening the unrelenting grip of powerful intermediaries and outside authorities on exchanges is the entire driving force behind blockchain, but centralized exchanges still happen within this medium.

Centralized Exchanges

Despite blockchain’s philosophy to put control in the hands of the people, you’ll find centralized exchanges happening on this platform all over the place. For-profit companies have hopped on this trend to make a buck by leveraging hype while circumventing the philosophy that created the hype in the first place, much to the chagrin of cryptocurrency developers.

A centralized exchange is one in which a central platform for exchanges charges fees for users and producers to trade. They take a cut out of every exchange to make a profit. Putting those platforms in the hands of users was meant to alleviate this problem, but there are some cryptocurrency exchange-oriented companies who are acting as intermediaries in this same way.

These companies charge fees at both the entry and exit point of an exchange. Since access to their platform is only granted when you abide by their rules, they’re acting as a central authority on the entire exchange, effectively taking control of the exchange back from the hands of the people.

Decentralized Exchanges

A decentralized exchange removes the intermediary from the equation, and it’s the only kind of exchange that embodies the philosophy of blockchain. Instead of paying to access an exchange platform through a central source, every exchange works through a collection of nodes all governed by a peer-to-peer protocol. That means that instead of a company providing the platform, everyone on the network contributes to the platform by which the exchange takes place virtually eliminating trading fees.

The reason centralized exchanges still have so much traction in the world of cryptocurrency is because they’re much easier to perform. All you have to do is set up the trade you want, and programs take care of the rest in the background. In some cases, this is as easy as searching sell orders and simply accepting one. Once you accept, and pay the necessary fees, the programs on a central authority’s platform go to work for you and complete the entire transaction.

Alternatively, decentralized exchanges require much more direct involvement in the process which usually consists of multiple transactions. For example, you may have to transfer funds from your wallet to the exchange, create an order for trade, transfer the funds back to your wallet, then wait for a response. Because decentralized exchanges are harder to complete and generally take longer, there’s a significantly lower trading volume, which in turn makes it harder to turn your cryptocurrency into cash.

Security Benefits

When you put the security of your exchange in the hands of a third party, as you would during any centralized exchange, you have to rely on them to keep your information and assets secure. People tend to trust these third parties to maintain adequate security standards, but many don’t, and that can be a serious problem. Companies overseeing cryptocurrency exchanges aren’t regulated, so there are no set security standards that they’re legally obligated to follow.

When you participate in a decentralized exchange, you never have to worry about a centralized source holding onto your funds for you. Since you’re connected directly to the other person you want to trade with, you don’t even have to take your funds out of your wallet until you’re ready to complete the transaction.

The Inevitable Shift

While centralized exchanges are the most prominent at the moment, decentralized exchanges look to be the future of cryptocurrency. The primary factor driving the use of centralized exchanges is how easy they are to use. As decentralized exchange solutions become more user-friendly, the advantages will far outweigh what you can gain from using a centralized exchange.

Regardless, decentralized exchanges are the only way to fulfill the philosophy that drove the creation of blockchain technology in the first place. Expect the for-profit companies that survive on centralized exchanges to fight back, but remember that cryptocurrency puts power in the hands of users. If you want to get the most out of your investment, learning about decentralized exchanges is going to put you in a better position moving forward, and will help protect your funds as soon as your next exchange.