Decentralized vs Centralized Exchanges: A Quick Overview
The future of cryptocurrency exchanges seems to be shifting towards decentralized exchanges slowly but steadily. It may replace our centralized exchanges one day, at least that is what most people in the crypto space firmly believe. Before we go any further, let’s understand what we mean by centralized and decentralized exchanges.
Centralized and Decentralized Exchanges
Centralized Exchange – Every exchange of this type has their own order book which receives and reviews all trade orders and matches them accordingly using their own software and servers. In short, the order is processed by an internal closed system.
Decentralized Exchange – Naturally decentralized exchanges, instead of relying on their own servers, operate on a network of computers. To search and match orders, decentralized exchanges can either use smart contracts or use second-layer networks of trusted nodes called relayers.
The main reason the majority of exchanges are centralized today is that these are user-focused. These exchanges are very easy to use, have a much lower learning curve and offer better liquidity for their crypto coins.
Since the people who run these exchanges are in for profits, these are more client-focused and therefore usually have a dedicated support team for users. For better user experience, they keep adding more features regularly as well as updating them. And undeniably, because of the profit-making nature and service, centralized cryptocurrency exchanges are bound to have a certain level of accountability to solve any issue.
Next, we discuss the issues associated with custodial exchanges, which applies to most centralized exchanges.
Concerns with Custodial Centralized Exchanges
While custodial exchanges take away your coins custody, it also means that they are liable to protect your fund, not you. The most significant advantage it offers in return is the ease of use. Instead of securing a private key, which can be a tedious job, you can access your wallet (i.e. your account wallet in the exchange) by simply authenticating your username and password. However, since most of these custodial exchanges are centralized, this has raised some serious concerns coupled with the immature state of regulation. Once a hacker gets hold of the private key to the exchanges, they can wipe out its users’ funds. For this reason, centralized exchanges have employed a cold storage system to keep the bulk of funds there but the fault remains.
Then there usually are concerns over price/market manipulation and there is also the threat of an exchange run. This would be a scenario where more people withdraw from the exchange than the exchange can pay.
Another typical issue with centralized exchanges is related to expensive fees. Because firms run them for profit in exchange for their service, the conversion rate is not always great (a large user baser takes the competition off their shoulder) and the various fees associated with trading and other services can get quite high depending on market activity.
Therefore, in short, custodial centralized exchanges have the following points going for and against them:
- Easy exchange of fiat to crypto
- Offers familiar interface
- Better customer support
- An easy target for hackers – a single point of attack
- Demands higher fees usually
- Lack of privacy
Now let’s check the non-custodial exchanges. Instead of managing user wallets, non-custodial exchanges have their own order books to match users’ trade orders and pay that service fee.
So what are the advantages non-custodial exchanges offer?
Since the users hold their own money, not the exchange, you as a trader will always have access to your funds. This also means that these exchanges offer better privacy and more security. Another advantage they enjoy is that they usually require less security support than custodial types.
Users deposit their coins into smart contracts (make sure to check they were audited by a respected blockchain security firm) which do not have private key control. Therefore, it is very unlikely for any hack to happen, thus avoiding counterparty risk.
Non-custodial exchanges are regarded by many in the crypto space as the most secure trading platforms. However, there are drawbacks as well. You have to take care of your own funds and there is little to none customer service available for these types of exchanges. Non-custodial exchanges do not offer the facility to convert fiat currency to cryptocurrency. This has prompted several efforts to peg a cryptocurrency to the dollar.
In short, the non-custodial exchanges offer the following advantages and disadvantages:
- Much better security as there is almost zero chance of a hack
- Users have access to their funds all the time
- Almost non-existent customer service
- Low liquidity level
- Security depends on your third-party software and services
- Unknown internal mechanics
Finally, we come to decentralized exchanges.
Now, there are four core functions to every exchange: capital deposits, order books, order matching and asset exchange. Now, if you want a fully decentralized exchange (DEX), then each of these functions has to be decentralized.
Types of Decentralized Exchanges
Two types of decentralized exchange models exist based on the way they transact currencies: Currency-centric and currency-neutral. Note here that both can be centralized or decentralized, based on how the exchange in question handles those four key functions.
The currency-centric exchanges are built on top of a single blockchain platform like Ethereum. The traditional exchanges are built like this. This type of exchange can only escrow those currency(s) that belong to the platform it is built on. For example, an exchange based on Ethereum can only escrow ERC20 assets and other related contracts.
The currency-neutral model is rather new. This exchange type is engineered to connect different native cryptocurrencies, so there is no need for users to abide by any specific cryptocurrency ecosystem.
These exchange types allow you to trade cryptocurrencies without a coin underlying that exchange, which acts as a kind of an additional “middleman” to go through since it is no longer a fully peer-to-peer transaction. These new models not only allow for asset exchange but also for securely matching and handling order books in a decentralized manner using the blockchain.
An exchange hosts a community of users, therefore there has to be a way to broadcast and match orders. One way trustless trading is done is through the use of atomic swaps for order matching but it is done from one peer to another and the two-way transaction happens at the same time. Since it cannot be used for broadcasting, the atomic swap alone is not sufficient to create this type of trustless marketplace. To create that trustless marketplace, smart contracts act as a trustless escrow holding onto one currency until the other party sends their fund, and then only both currencies can be released.
Advantages of Decentralized Exchanges
Before allowing you to trade, most centralized exchanges ask for a lot of your private information like your name, id, bank account number, etc. to sign up for your exchange account. To comply with government regulations, anonymous crypto-to-crypto exchanges also ask for your location information and other personal details. Decentralized exchanges on the other side, use blockchain information to operate and therefore, in the ideal case, only need your public address.
As of now, contributing in only a small percentage of the entire crypto trading volume, DEXs doesn’t come under any government regulation (though the idea of decentralization is to be out of the government’s control or any central body). However, as the paradigm shifts in favor of DEXs, they can face regulations in the near future.
Following up from the previous, decentralization thrives on the idea that nobody can control it. Unlike a centralized exchange, the government can neither track the transactions nor put a tab on it, nor can forcefully impose any taxes or other regulations on decentralized exchanges.
Decentralized exchanges exist across a network of computers. Therefore it is much more complicated to attack due to the lack of a single point of failure. This also makes DEXs much more difficult to design and test, which is one of the reasons why DEX development has experienced slow development.
Big exchanges have been under heavy DDOS attacks. The primary advantage DEX offers is privacy. DEX doesn’t offer its own hot wallet; instead, the user can choose other hot or cold wallets and has complete control of their personal wallet, thus removing their personal information from the hackers.
In DEXs there is no single point of failure, meaning even if one node or multiple nodes go down due to attack or maintenance work, the rest of the DEX nodes will keep it up and running. This vastly reduces the downtime of the exchange and makes the rollout of updates easier, which, by the way, happens on a node-by-node basis.
The potential for Higher Transaction Speed and Lower Cost
DEX doesn’t need any third-party authenticator and hence has the potential to offer faster transactions at a reduced transaction cost. This is currently theoretical though as DEX needs to reach a certain level of network population called critical mass to make this happen.
The Potential for Benefitting Larger Trade Volumes
With no centralized server keeping any critical information, including user funds, hacking is entirely out of the picture. This makes DEX a better choice and practical for trading large volumes, but, as explained in the drawback section, the scenario currently is a bit different
Adoption of New Digital Assets
Top centralized exchanges many times charge a high fee for listing new coins. These listing charges are ineligible in case of decentralized exchanges. Therefore, it presents firms’ opportunity to enlist their digital coins without the initial costs, thus driving the likelihood of its growth.
Another advantage of DEX is it needs very little money (compared to centralized exchanges) for maintenance. Since there is no need to offer a hot wallet to the users, the cost is brought down substantially. Decentralized exchanges do need money to sustain themselves, but that can be collected from charging a very low fee each time a user transact, thus abiding by the original idea of the blockchain.
Decentralized Exchanges Examples: UniSwap V2 and RskSwap
Uniswap V2 is probably the most popular DEX in the crypto space. Another option that has recently been announced is RSKSwap. RSKSwap is a class of decentralized exchanges that rely on mathematical formulas to set a token price. This allows users to swap ERC20 tokens while instantly charging a 0.3% fee. The fee charged here goes to users that lock up their tokens on Uniswap, aka, liquidity providers.
The main advantages of RSKSwap are:
- It is free from centralized control.
- It’s permissionless and open for everyone to use.
- The system is secure.
- It’s free from censorship allowing the unimpeded flow of transactions.
So, who created RskSwap?
RskSwap is a fork of the Uniswap V2 Protocol, which as mentioned happens to be the most widely-used decentralized exchange (DEX) on Ethereum. Created by thinkanddev.com, RskSwap plans to empower developers, liquidity providers and traders to participate in an open and public financial marketplace.
Swapping is intuitive, a user picks an input token and an output token. They specify an input amount and the protocol calculates how much of the output token they’ll receive. They then execute the swap with one click, receiving the output token in their wallet immediately. You just need to use the Dapp, have Nifty Wallet or Metamask installed and enough RBTC to pay the transaction and the token you want to swap.
Can I list ERC20 Tokens on RskSwap?
Any ERC20 token can be listed on RskSwap. Each token has its own smart contract and liquidity pool. If there is none, it can be created easily. Once a token has its exchange smart contract and liquidity pool, anyone can trade the token or contribute to the liquidity pool while earning a liquidity provider fee of 0.3%.
How are RskSwap tokens produced?
To understand how this happens, simply follow these steps:
- The contributor who introduces a new pair to the RskSwap liquidity pool receives a “pool token.”
- These pool tokens are ERC20 tokens.
- Pool tokens can be freely exchanged, moved, and used in other dapps.
- Pool tokens are burned when the funds are reclaimed.
- Each pool token represents a user’s share of the pool’s total assets and share of the pool’s 0.3% trading fee.
Decentralized exchanges have undoubtedly gained a lot of attention and crypto savvy users so far. However, we still have some ways to go before we can safely move on from centralized exchanges. In the meantime, protocols like RskSwap show us that we are at least moving in the right direction.
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