Cryptocurrency trading platforms, both centralized and decentralized, offer diverse features and varying levels of security for users. In a time when there is growing scepticism over the reliability of cryptocurrencies, it is more important than ever before to have a trustworthy, secure, and accessible exchange to trade digital assets. Most people do not understand that they have two options to choose from: a centralized exchange or a decentralized exchange.
Understanding the differences between these two kinds of exchanges is fundamental in order to fully comprehend what each one offers, and what security issues may arise from trading on one rather than the other. Centralized exchanges, such as Coinbase, Binance, or Kraken, are based on a system where transactions on the exchange are handled by that very same exchange, the ‘third party’ in any trade taking place on the platform. While centralized exchanges often offer a simpler user interface as well as liquidity, these exchanges are ultimately in control of a trader’s funds and private information. As a result, centralized exchanges are left open to more potential security risks, including hacks and scams. The principal of decentralized control, which is what blockchain as a technology promotes, is also undermined using this model, because of the presence of a third party. This is the principal differentiation between the two types of exchanges, as decentralized exchanges offer more security for traders, since users have full control over all of their funds and transactions.
The volatility of the cryptocurrency market has been affected by problems with the trading platforms used for cryptocurrencies. Hacks on centralized exchanges leave traders open to scams and an immense loss of funds, and examples of this are unfortunately not uncommon. One of the largest and most infamous hacks was on Mt. Gox in 2011 and then 2014, where 1.35 million BTC, the equivalent of $473 million USD was stolen. In 2016, Bitfinex had issues with its multi-signature wallets features, leading to a loss of 120,000 BTC, or $72,000,000 USD of its clients’ funds. More recently, in 2018, Coincheck was hacked, with approximately $532 million USD stolen from the exchange. Traders on cryptocurrency exchanges need to be confident that their funds are secure, and these doubts cause potential future traders to be reluctant to begin trading in the first place. It is vital, in order for the cryptocurrency market to thrive, for traders to know that the platform they choose to trade on has limited and mitigable security risks. After all, security breaches can affect private data, as well as incurring possible trading fund losses.
Decentralized exchanges provide an obvious solution to these issues. By removing the need for a third party, decentralized exchanges allow users to have more control over their transactions. In an era where control over one's own information is more important than ever, and where hacks continue to occur regularly, it is prudent to opt for the more secure option.
In addition to security, decentralized exchanges offer several other benefits over the centralized exchanges:
Decentralized Exchanges Help Avoid Market Manipulation. Centralized exchanges, such as Bitfinex and others, have been accused of market manipulation. Since they have full authority to determine which tokens can be listed on the exchange, they have the potential to influence the financial market in unseen ways. This is not the case for a decentralized exchange — their market actions are transparent and accessible to everyone on the blockchain.
Decentralized Exchanges Can Operate as Exchanges Instead of Custodians. While it depends on which exchange is used, a majority of centralized exchanges operate as escrow accounts for crypto for their customers. Decentralized exchanges do not act as custodians and purely make it possible for two parties to trade with each other using smart contracts.
Decentralized Exchanges Offer Unprecedented Openness And Privacy. Due to the peer-to-peer nature of each transaction, decentralized exchanges allow trades to go beyond KYC and AML procedures. This is unlike centralized exchanges, where users need to provide these large entities with personal data and trust that the exchange can and will protect it. Ultimately, decentralized exchanges provide a more seamless, sensible, and reliable alternative for trading.
Decentralized Exchanges Offer Higher Protection from Potential Security Breaches. By removing the need for custodians to operate the exchange, and by offering users increased openness and privacy, decentralized exchanges are a more secure investment option for cryptocurrency traders.This in turn offers higher protection from potential security breaches.
In time, I believe that we will see a paradigm shift towards using more decentralized exchanges due to the wide array of benefits they can offer users. It’s important to remember why digital assets were created to begin with — to remove third party entities and to grant individuals full ownership over their money. By removing the ‘middle man,’ decentralized exchanges remain true to the nature of cryptocurrencies and blockchain technology, and by eliminating the most vulnerable point for attacks, they increase security dramatically.
James Bowater in conversation with David Holtzman, DSTOQ's Chief Security Officer.