How Centralized Exchange Works: Pros, Cons, Are they Secure?

How Centralized exchange works
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How Centralized Exchange Works

The Blockchain and cryptocurrency space is broad and gaining mainstream adoption, with everyday people looking to utilize one or the other. This review displays how Centralized exchange works. Some examples of Centralized exchanges include Blockchain.com, Currency.com, Tidex, etc., which all facilitate the buying and selling of cryptocurrencies.

Although interacting with Centralized exchanges poses certain risks, like leaving your funds in the hands of Centralized exchanges (CEX), you have to trust completely that whoever is in charge will act in your best interest without compromise or bias.

The fact that Centralized exchanges hold custody over users’ assets makes them a lucrative target for potential attackers from both outside and within the organization. In 2019, over $292 million worth of customer funds have been lost due to CEX hacks.

Just like the fallout of the FTX centralized exchange going bankrupt, which was due to the misuse of investors’ funds and drastically affected the cryptocurrency ecosystem. Ethereum co-founder Vitalik Buterin shared his thoughts on the failure of the cryptocurrency exchange FTX. He said:

What happened at FTX was of course a huge tragedy. That said, many in the Ethereum community also see the situation as a validation of things they believed in all along centralized anything is by default suspect.

That being said, I’d like to think that “Not all Centralization is bad and Not all Decentralization is good.” It doesn’t go without saying that centralized exchanges play a huge role in the Blockchain and cryptocurrency ecosystem.

What are Centralized exchanges?

Centralized exchanges (CEX) are exchanges that are controlled by a central body that facilitates the buying, selling, and trading of cryptocurrencies and other commodities.

As of 2020, CEXs were the most widely adopted mode of operation for cryptocurrency exchanges. The speed and cost-efficiency of processing transactions by a single point of authority make them a convenient venue for day traders and crypto investors to buy and sell crypto.

Pros and Cons of Centralized Exchanges

Pros

  • Intuitive and intelligent UI: This is necessary for facilitating ease of use.
  • Liquidity: Consistently high liquidity.
  • Volume: Centralized exchanges have been known to account for the vast majority of trading volume.
  • Speed: Fast transaction speeds on Centralized exchanges contribute to better user experiences as well as enable complex trade types.

Cons

  • Highly vulnerable to hacking: Because they hold a large number of assets, centralized exchanges are a prime target for bad actors. The most notorious exchange hacks were aimed at centralized exchanges.
  • Custody: Entrusting an exchange with your private keys means you don’t fully control your own money.
  • Manipulation: Several Centralized exchanges have been accused of manipulating their opaque nature and conducting insider trading, fake volume, and price manipulation.

How Centralized exchange works?

Well, Centralized exchanges are totally managed and owned by a single authority, so investors and traders must place their confidence in this Centralized authority in order to carry out more exchanges.

Before utilizing Centralized exchange services you have to complete the signup process which takes just very few steps after which you’ll have to go through the KYC process to get your account verified before you begin transacting on the exchange. 

CEXs generally require that users deposit their crypto assets at the exchange before trading can happen. Whether it’s fiat or crypto, once deposited, they are under the custody of the exchange. This means that you’re now trusting the exchange to keep your funds safe the same way you’d trust a bank’s vault to hold your money.

Having completed the above processes, you now have access to a platform where buyers and sellers can transact with each other. This means that you buy crypto from another user of the exchange rather than from the exchange itself.

It matches buy and sell orders. I.e., If a buyer wants to buy bitcoin (BTC) at $5,000 and a seller wants to sell bitcoin at $5,000, the exchange matches the orders of these two people. It also announces the current market prices based on the last price an asset was sold for.

Centralized exchanges with KYC

Since its inception, centralized exchanges have evolved, integrating features that make them maintain safety, reliability, and transparency. KYC in Centralized exchanges is of the essence because of the increasing influx of users trying to utilize one service or the other. 

Buying and selling of cryptocurrencies in Centralized exchanges pose certain risks like the risk of anonymity in the sense that you don’t know who you’re interacting with. Like when it comes to buying and selling cryptocurrencies, for instance, this makes you curiously wonder: if I deposit this fiat currency into the provided account, will the person on the other end release the crypto I’m trying to purchase? 

So KYC is implemented to make sure you’re not gambling with your funds but actually getting your desired outcome, which is obtaining the cryptocurrency you paid for.

Hence, Centralized exchange without KYC makes you liable to all kinds of risk, but with the help of KYC in Centralized exchanges, the identification process helps the exchange know who you really are by submitting valid documents of identification like an ID card, DL, SSN, and more. 

Centralized exchanges have implemented a know-your-customer (KYC) process to identify each user with an account, eliminating the ability for users to have multiple accounts, all to keep the exchange safe from bad actors. You can learn more about KYC in Centralized exchanges.

Centralized exchange Vs Decentralized exchange

Centralized Exchange

Centralized cryptocurrency exchanges, as the name implies, function as an intermediary between buyers and sellers. Almost all crypto transactions are conducted through Centralized exchanges, which provide greater trustworthiness.

Centralized exchanges are platforms that allow users to buy and sell cryptocurrencies for fiat currencies such as the US dollar or digital assets like BTC and ETH. They operate as trustworthy brokers in deals and frequently serve as custodians, keeping and safeguarding your cash.

Decentralized Exchange

Decentralized exchange is a non-centralized alternative to Centralized exchange. Here, there’s no chain of command, and no single entity is in charge of the assets. 

In contrast to traditional centralized exchanges, smart contracts and decentralized applications (DAPPS) are used to automate transactions and trades, thus keeping you in control of your assets.

This method is proven to be safer since no security breach is possible, provided the smart contract is properly constructed.

Here’s a basic breakdown of the differences between Centralized exchange and Decentralized exchange:

CriteriaCEXDEX
DecentralizationIt is operated by a centralized organizationIt is operated by users in Automated Market Maker (AMM)
Custody of AssetThe Centralized exchange is in charge of the crypto assetsHere users have complete and absolute control over their assets.
SecuritySince third parties are involved transaction might be at risk due to cyberattacks of hacking.Provides higher security since a group of validators verify every transaction.
LiquidityHigh liquidity is created due to institutional investors and a large user base. Lack of regulatory standards and lesser user base reduce liquidity.
FeesContains several fees charged by the network which inclde: trading, withdrawal, deposit, and maintenance fee.It is more cost efficient with zero commision and trade fees but charges swap fees.

How Centralized exchange works: Bottom line

Centralized exchanges (CEXs) are organizations that coordinate cryptocurrency trading on a large scale, using a similar business model to traditional asset exchanges like stock exchanges.

They are useful when a large number of people may be simultaneously trying to buy and sell the same type of asset. Even though they have security concerns as they have become a prime target for hackers, their essence cannot be overemphasized.

As of February 2022, CEXs are still far more common than decentralized exchanges (DEXs). KPMG found that they accounted for around 95% of exchange crypto trading and have also become the most valuable business in the crypto world.

Disclaimer: The information on AlteBlock reflects the authors’ personal opinions. It does not represent AlteBlock’s opinions on whether to buy, sell, or hold specific investments. It is suggested that you conduct your own research before making any investing decisions. You use the information at your own risk. See Disclaimer for additional details.


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