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We are living in a world where digital assets are becoming more and more popular. This is thanks to the digitalization that is going on all over the world, and everyone is trying to move to the online landscape because of the unlimited possibilities this field brings.
Cryptocurrencies are one of the most popular digital asset classes right now and a large number of people are gaining interest in this new financial market. While cryptocurrencies have a lot of uses across different aspects online and in the real world, most of them move around crypto exchanges. In this article, we will be taking a look at these crypto exchanges and discuss what types of crypto exchanges there are, how they work, what their advantages and disadvantages are, and other relevant information.
Simply put, crypto exchanges are places where individuals and businesses can buy, sell, and trade with cryptocurrencies. What this means is that when visiting crypto exchanges, you can swap one cryptocurrency for another, or use fiat currency to purchase crypto. In most cases these trades happen between two traders and exchanges simply play the role of intermediaries and take small fees for doing so.
But as we know, the world of blockchain and cryptocurrencies is very diverse. Because of this, not every person is looking for the same services when it comes to these crypto exchanges and there are many different types of crypto exchanges. Let’s take a look at these exchanges to see how they work and what the differences between them are.
The most popular type of exchange is a centralized exchange. All of the biggest exchanges, such as Binance, Coinbase, and Kraken are centralized exchanges that are controlled by one single entity. These centralized exchanges connect buyers and sellers, and they themselves play the roles of intermediaries.
There are many different reasons why centralized exchanges are the most popular types of exchanges, and we will highlight some of their most advantageous aspects below.
User-Friendly: Centralized exchanges are oriented to be user-friendly. They know that the vast majority of people who are involved with cryptocurrencies are newcomers to the financial world of trading and investing, and that crypto is a complex asset. Because of this, centralized exchanges are trying to make their platform easy to use. It does not matter what level of experience someone has, they should easily be able to get acquainted with the platform and be able to use most of the tools offered.
Big Selection of Trading Tools: Another benefit of centralized exchanges that makes them so popular is the numerous trading tools that are available on these platforms. The most common way to trade cryptocurrencies on centralized exchanges is using the spot market, where you simply exchange one cryptocurrency for another based on the prices at that moment in time. But there are also other options. Futures trading is probably the most important part of centralized exchanges. When trading with futures contracts, traders can try to guess whether prices will go up or down and make profits if their guess was correct. There is also the possibility of using leverage, which will increase the trading power of the trader and provide them with additional funds to trade with.
These are just two examples of trading tools that are present on these centralized exchanges, and most exchanges have other tools as well, such as crypto staking, crypto lending, P2P, and more.
High Level of Security: Security is one of the top priorities for centralized exchanges and they make sure to protect user funds as much as possible. While centralized exchanges use custodial wallets, and cryptocurrencies you store there are not stored on your personal wallet, there are some security benefits that centralized exchanges bring. First of all, most of the assets that exchanges hold are stored in cold wallets which are disconnected from the internet and impossible to hack into. Centralized exchanges are also regulated by certain government bodies, and with that, they can benefit from stuff such as insurance. For example, exchanges that are regulated in the US have FDIC insurance that covers $250,000 for each customer in case their assets are stolen.
Centralized exchanges also implement verification methods such as 2FA, which helps exchanges protect users' accounts and funds, by making sure that the person who is trying to access funds is actually the person who owns them.
When it comes to how these centralized exchanges work, they use order books to manage their markets and make sure that transactions go through. The order book is a mechanism that connects sellers and buyers together and executes transactions. What this means is that, whenever you place a buy order on the market for a specific price, the system takes a look at the order book to see who is selling that cryptocurrency for the price you wish to buy at. After this, two parties are paired, orders are executed and everyone is left with what they asked for.
But when it comes to the way centralized exchanges work, they have a few negative sides to them as well. Every centralized exchange breaks a few of the biggest principles that are pushed by cryptocurrencies.
The first big problem with centralized exchanges can be seen in their names. Cryptocurrencies have been created to fight centralized systems and don’t give one single entity control over everything. But centralized exchanges are run by one single entity which decides everything that goes on with the exchange, they decide fees, what people can trade with, they have the ability to freeze people's accounts, and so on.
Another problem with the way centralized exchanges work is the lack of anonymity. Cryptocurrencies have been created with anonymity in mind, and that’s why we have crypto wallets that have simple addresses to send and receive funds, and no other personal information is needed. But when using centralized exchanges, traders are required to verify their identities and exchanges know the personal information of every single person on their exchange. This is done to comply with regulatory requirements, as most regulators require exchanges to have KYC verification before giving traders access to most of the tools available on the exchange.
Now let’s take a look at some of the advantages and disadvantages of centralized exchange. This will help you better understand what these exchanges are offering and what they are lacking, which will make it easier for you to make a choice, whether to trade here or not.
Another type of crypto exchange is decentralized exchanges. When it comes to big-name decentralized exchanges, there are Uniswap, PancakeSwap, and dYdX. As the name suggests these are decentralized trading platforms that are not controlled by any single entity and they are operating on smart contracts, rather than some individual decisions.
When trading on these exchanges, buyers and sellers are not connected with each other, and they operate based on liquidity pools and smart contracts.
While decentralized exchanges are not as popular as centralized ones, there are still some aspects of these exchanges that make them stand out and attract traders and investors.
Decentralized: As the name suggests decentralized exchanges are not run by one single entity and they are fully decentralized. What this means is that decentralized exchanges are run automatically using smart contracts and decisions are made by users as no single person is running the platform. These types of exchanges maintain the core principles of cryptocurrencies, as Satoshi Nakamoto created Bitcoin with decentralization as the main goal.
Full access to your funds: One of the biggest advantages that decentralized exchange offers is full control over your funds. When using centralized exchanges, the cryptocurrencies you trade with are stored in custodial wallets owned by exchanges and you don’t have access to the private keys of these wallets. But on decentralized exchanges, you are connecting your own crypto wallet, meaning that, the cryptocurrencies you are trading with are stored on your personal wallet and they leave it only when you exchange them for different cryptocurrencies, which then will be deposited back into your wallet.
Low-security risks: While centralized exchanges adopt very high-security measures, decentralized exchanges don’t need to do so, since they have very low-security risks. Since decentralized exchanges don’t keep user funds in custodial wallets, they don’t have big targets on their backs and it is less likely that they will be targeted by hackers or scammers. The only thing that decentralized exchanges have are liquidity pools where they store cryptocurrencies, but these cryptocurrencies are usually highly protected thanks to blockchain technologies, and hacking into them is practically impossible unless the exchange makes a very crucial error and lets it guard down.
As we mentioned above, decentralized exchanges are run on smart contracts. Smart contracts are codes that are written into the blockchain and they execute different orders and contracts that are taking place outside of the blockchain. Since decentralized exchanges are run on these smart contracts and don’t use order books, they complete these trades using liquidity pools. Each decentralized exchange has a liquidity pool of two or more cryptocurrencies. For example, there can be a liquidity pool of Bitcoin and Ethereum. When traders want to exchange their Bitcoin for Ethereum, they create an order, then using smart contracts, the exchange simply takes traders' Bitcoin and puts it in the liquidity pool and takes out an equivalent amount of Ethereum from the liquidity pool and gives it to the trader. This is a simplified explanation, and of course, if we take a deeper look, it becomes more complex.
While decentralized exchanges bring many benefits to the blockchain ecosystem and keep the core principles of cryptocurrencies, there are still some downsides to these exchanges. These are pretty big downsides, which is why they are less popular than centralized exchanges and are more designed for experienced people who are deeply involved with cryptocurrencies and blockchain.
One of the biggest downsides to decentralized exchanges is the lack of trading tools. Since decentralized exchanges are not regulated, they are not able to offer trading tools such as futures trading or leverage. These two are some of the most popular ways to trade cryptocurrencies and their absence affects these exchanges greatly.
Another downside to decentralized exchanges is their complexity. This is not a place where complete newcomers can come for a visit and use things comfortably. In order to take full advantage of the benefits offered by decentralized exchanges, traders will need to have some level of knowledge about crypto and blockchain. Traders are required to know how to own and operate personal crypto wallets, they also need to know how liquidity pools work, and more. In general, things are not simplified on decentralized exchanges and a lot of stuff needs to be done by hand, and this is why it is not great for beginners.
Decentralized exchanges also suffer from low liquidity. Since these exchanges operate on liquidity pools, they are dependent on people providing this liquidity, and there are times when you might not be able to trade with tokens you want to, or might have to pay more than market price since prices on these decentralized exchanges depend on liquidity pools. To combat this, decentralized exchanges offer rewards to those who provide liquidity, but it still is not enough to attain a liquidity size equal to, or even close to centralized exchanges.
Looking at these decentralized exchanges, we can see that they have their own advantages and disadvantages. Since this is a very complex type of exchange, it is important to know about these advantages and disadvantages in order to make a correct decision on whether you should use them or not. Because of this, let’s take a look at what these decentralized exchanges are good and bad at.
Looking at information about centralized and decentralized exchanges, we can see that both of them have their strengths and weaknesses. Hybrid crypto exchanges are a combination of these centralized and decentralized exchanges as they try to take the best aspects of both exchanges and combine them under one umbrella.
While each hybrid exchange will have its own approach to this combination, there are primarily 4 aspects that these exchanges are trying to combine. They take the usability and liquidity of centralized exchanges and combine them with the anonymity and security of decentralized exchanges.
When trading on hybrid exchanges, traders can use different trading tools and trade on highly liquid markets. But alongside this, hybrid exchanges give users the ability to remain anonymous and trade safely using their wallets. What this means is that traders can use their own, non-custodial crypto wallets to trade on these hybrid exchanges, and do so without creating accounts and passing KYC verifications.
Some hybrid exchanges might still be regulated and anonymities might be removed, but one thing that hybrid exchanges will be able to provide indefinitely is the ability to use personal crypto wallets, so users don’t have to worry about their funds being stored on wallets owned by third parties.
One of the least popular types of crypto exchanges is OTC exchanges. OTC stands for Over The Counter, and it refers to trades that involve large amounts of money and are done outside of the traditional market. This type of exchange is primarily used by institutional investors and those that deal with very large quantities of cryptocurrencies, as OTC exchanges are designed to satisfy their needs.
Cryptocurrencies are highly volatile assets, which means that their prices can have significant movements in a very short period of time. Because of this, there is always a possibility that traders will suffer from slippage. Slippage is when your order is executed at a different price than indicated. So if an order does not get executed immediately, there can be a shift in prices and slippage can occur. This is more likely to happen if we are making a very large trade since the market might not be liquid enough to execute the order immediately, and these institutional traders are the ones who execute these large orders and they are more likely to suffer from slippage. When making these large trades, these traders have everything calculated beforehand and even a small change can damage their goals.
This is where OTC exchanges come into play. When using crypto OTC exchanges, traders get the opportunity to trade privately outside of the market. What this means is that, if they wish to exchange large amounts of one cryptocurrency for another, OTC exchanges prepare the crypto these traders are looking for. Once an OTC exchange has these cryptocurrencies ready, traders can complete trades in a very short time and avoid slippage, as orders will be executed pretty much immediately.
There are mostly two types of OTC exchanges. The most common ones are ones that are implemented into centralized exchanges. Some centralized exchanges have their own OTC exchanges and traders can simply visit these exchanges and execute their trades. There are also specially designed OTC exchanges that only deal with institutional traders and don’t give regular traders access to their platform.
P2P exchanges are crypto exchanges that connect sellers and buyers and trades happen outside of the market. When visiting centralized exchanges, traders are paired based on order books and they don’t have control over who they are buying and selling from. While on decentralized exchanges, trades are done through liquidity pools. While these are good and popular trading systems, there are still some people that would prefer to have more control over their trades.
This is where P2P exchanges come into play. When visiting P2P exchanges, you will be able to see different people who are buying or selling cryptocurrencies. These traders will have every detail provided, such as which crypto they are buying or selling for which crypto, at which rate they are trading, and other necessary information. Once you see someone whose offer you like, you can simply trade with them following the terms indicated. You can also create your own order and wait for other people to trade with you.
Just like OTC exchanges, P2P exchanges can be found in regular centralized exchanges as well as dedicated P2P platforms. Most of the P2P exchanges that are not part of centralized exchanges are open-source, decentralized platforms that are specially designed for P2P trading while keeping anonymity and decentralization.
When looking for the safest crypto exchanges, the first choice should come down to decentralized exchanges. While these exchanges might not have high levels of security, they don’t use custodial wallets, meaning that users' funds are never stored there. Because of this, hackers can not access users' funds even if they hack into these decentralized exchanges. If we are looking at centralized exchanges, then Coinbase has some of the best security measures, when it comes to protecting users' funds and safety.
The answer to this question comes down to personal preference. If you are looking to simply exchange one cryptocurrency for another and don’t need access to a large selection of trading tools, then using a decentralized exchange is a good idea. But in order to take full advantage of decentralized exchanges, you will need to have some basic knowledge of cryptocurrencies and blockchain. While if you want to have access to a wide range of trading tools and make big profits from trading cryptocurrencies, then using centralized exchanges is probably the best option.