DYOR Crypto Wiki

"An ordinary digital asset exchange is a web application that runs on centralized servers. It is typically not open source. It must manage users’ login data, such as their email addresses and passwords, as well as their KYC documents (if the exchange requires them). We can refer to exchanges of this variety as centralized exchanges (CEX).

To make trades on a CEX, users must deposit funds upfront. It’s clear why this is a requirement, as users should not be allowed to make trades with funds they do not have.

However, the deposit process can take up to an hour or more, as most exchanges require a high number of block confirmations before the funds are considered safely deposited. This model also forces users to forfeit control of their funds when making a deposit to a CEX. 

As such, a traditional centralized exchange controls all of the funds deposited by its users. All funds are controlled by a few (or in some cases by just one) person(s). This forces them to manage many different crypto wallets, as no wallet can hold all every digital asset in existence. So an ordinary CEX must manage many high-value wallets to securely store their users’ funds while the users trade.

Centralized exchanges use a credit system, sometimes called an IOU system. This means that when a trader deposits funds, her account gets credited accordingly and then she can create buy and sell orders. 

So, if Alice deposits BTC, she can place a buy order for another digital asset, like KMD. This can be thought of as buying KMD with BTC, or it can be thought of as selling BTC for KMD. Once the trade is complete, Alice can submit a withdrawal request and have her KMD sent to her personal wallet. This is essentially “cashing in” the IOU that the exchange issued to her.

Now that we’ve covered what centralized exchanges are and how they work, we can begin to understand their limitations and challenges.

Custodial Trading 

As described above, all CEXs take custody of traders’ funds. All the funds are consolidated into a few high-value wallets. These wallets’ private keys are always under the control of the exchange’s leadership. 

When you consider that CEXs might have tens or hundreds of thousands of users, it’s easy to see how these wallets quickly become a liability. Taking custody of users’ funds forces CEXs to manage and safeguard massive amounts of wealth, making them an extremely lucrative target for hackers and bad actors.

Security Vulnerabilities

Security is a huge concern for CEXs. Over the last 10 years, hackers have stolen more than $1.5 billion from centralized exchanges. In fact, research groups estimate that hackers stole somewhere between $950 Million and $1 Billion from centralized exchanges in 2018 alone. Many exchanges— Mt. Gox, Youbit, Cryptopia— were forced to file for bankruptcy and shut down as a result of hacks.

If a retail bank gets robbed, and all of that bank’s money is stolen, the customers of that bank still get their money back. This is true because, in most developed nations, banks are insured by the government. 

In the United States, for instance, the Federal Deposit Insurance Corporation (FDIC), established by the 1933 Banking Act, in the midst of the Great Depression, provides insurance to all licensed commercial banks, insuring each account holder up to $250,000 USD.

For better or for worse, none of this holds true for CEXs. If a centralized exchange is hacked and goes bankrupt, all of the users who had funds on that exchange are not guaranteed reimbursement. Their funds may be gone forever. That’s why it is so crucial to take security very seriously, and why many savvy users refuse to keep their coins on a CEX.

Deposits, Withdrawals, and Fees

Before making trades on a CEX, users must deposit their funds to the exchange itself. This process is free but it generally takes time. Exchanges force users to wait for a high number of block confirmations before giving them access to their funds for trading.

Moreover, when a user wants to stop trading and withdraw their funds to a private wallet, they need to create a withdraw request and pay a fee. This is reminiscent of the way that big banks operate— forcing customers to pay a fee for reclaiming funds that belong to them in the first place. In return for allowing an exchange to hold your digital assets, and potentially profiting off the additional funds in their possession, you are granted the privilege of paying a fee to get your own funds back in your own wallet.

Withdrawal fees are paid in addition to trading fees. While trading fees vary from exchange to exchange, they are typically 0.2% of the value of every trade for both the buyer and the seller. You can imagine how quickly these fees add up. 

Binance, for example, was reportedly more profitable than Deutsche Bank, the largest bank in Germany, in 2018. Despite a prolonged bear market, Binance collected $200 Million in profit in the second quarter of 2018 alone.

Restricted Trading Pairs

Another disadvantage to CEXs is the limited number of trading pairs available. Apart from BTC and ETH, each asset typically has only one or two trading pairs with high market capitalization assets. This creates unnecessary steps when trading between two digital assets with lower market capitalizations.

For instance, if you want to trade a OmiseGo (OMG, an ERC-20 token) with Monero (XMR, a privacy coin with its own unique protocol), you would need to trade from OMG to ETH and then from ETH to XMR. It wouldn’t be possible to trade directly from OMG to XMR. 

This is because CEXs want to corral traders into a comparatively limited number of trading pairs to ensure adequate liquidity. CEXs could allow asset-agnostic trading but they choose not to.

For a truly decentralized exchange, all of the challenges described above are overcome."