Decentralization is the process of devolving decision making powers from a central authority to subordinate units. Centralization on the other hand is the opposite. Hence, good comparison between decentralized and centralized exchanges is very needful. One of the interesting things about cryptocurrency is that it cannot be controlled by any central entity.
Take the Bitcoin network as example, any transaction or transfer of value that occur on such a peer-to-peer system does not require the involvement of central entity, because transactions are validated by a distributed and independent group of nodes called miners which operate on the network.
However, this idea of decentralization that exists with Bitcoin and other cryptocurrencies has not been fully realized with regard to cryptocurrency exchanges. A vast majority of trades in the cryptospace are still made on centralized exchanges, as opposed to decentralized exchanges.
In centralized exchanges, intermediaries such as companies act as middle men in order to facilitate trading on their platform. They collect trading fees in exchange for providing this service. Many individuals want an interface that can connect them to both cryptocurrency trading and the real world economy, and centralized exchanges provide that.
Centralized exchanges operate with matching algorithms that automate the buying and selling processes on their platforms. For example, if Rex wants to buy 2 Bitcoins, there are two ways he can do this.
Rex can go to the order book and find an offer that he is willing to accept and if he is willing to buy 2 Bitcoins at the set asking price, then his buy order will automatically be matched with a corresponding sell order that meets his requirements. Rex could also create his own buy order, this allows him to set the terms of the trade, initiating the terms such as price and quantity.
Interestingly, decentralized exchanges do not require intermediaries to operate just like their centralized counterparts. A pre-programed matching exchange software facilitates the entire process, so that they will be no need for any intermediary intervention.
Instead of matching buy orders and sell orders in an order book, a decentralized exchange operates by matching the traders behind those buy and sell orders. For example, if Rex wanted to buy 2 Bitcoins, he would be directly matched with Frank, who also wants to sell 2 Bitcoins. From there, Rex and Frank can agree to a price between themselves and finalize their trade.
Decentralized exchanges have significant advantages over their centralized counterparts. For instance, the absence of an intermediary rules out the existence of trading fees. Decentralized exchanges are also more private-oriented, centralized exchanges often require KYC verification, demanding for personal information and proof of identity such as passport, in order to trade on their platform.
A decentralized exchange does not require you to disclose your identity, that is only required between you and the individual that you are trading with. Ultimately, the security of your assets are better off under the decentralized exchange model.
Decentralized exchanges do not hold cryptocurrency for users, instead, users have control over their private keys and are connected directly with each other, meaning that traders do not have to worry about the security of their crypto assets sitting on an exchange since everything is in their control.
See Also Cryptocurrency for Beginners (1)
Despite its many benefits, as at today the use of decentralized exchanges is simply not as popular as their centralized counterparts. This is one of the issues with trading on existing decentralized platforms. Due to the low patronage on decentralized exchanges, they have much lower trading volumes compared to centralized ones.
This means that finding an acceptable trade can be a very difficult thing. It also bears on liquidity; lower trading volume makes it harder to sell cryptocurrency and liquidate into cash. Decentralized exchanges also have the problem of 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 benefit from market movements will find it difficult to do so on a decentralized exchange. Lastly, decentralized exchanges currently do not offer advanced trading features such as margin trading and stop losses, making the case more difficult for traders to make good use of them.
The philosophy of the blockchain technology is decentralized and its benefits. In spite of this, the philosophy has not been fully realized in regards to how the majority users carry out trading in the industry. Due to some problems with decentralized exchanges at its early age, traders continue to overlook it for their centralized counterparts, that do currently offer significantly better trading functionalities. However, as the decentralized model continue progressive developments, it may likely be that we see a shift in preference to them.
Do you find this article interesting or have a suggestion to offer? Leave a comment in the box.