Centralized Exchanges Will Be The Death Of Crypto

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  • Centralized exchanges currently control a large share of the crypto trading industry, and this can create problems for crypto users.
  • Due to their centralized control, CEXs have many disadvantages, including security risks, data breaches, unstable operation, and enforcement of arbitrary policies on users.
  • Decentralized exchanges are needed to transform crypto into a truly trustless, peer-to-peer means of exchanging value.

Today, centralized crypto exchanges (CEXs) control more than 99% of the cryptocurrency trading market. Estimates released by The Block shows CEXs processed around $14 trillion in volume last year, with DEXs transacting a meager $1 trillion.

Centralized exchanges like Binance, Gemini, Coinbase, Kraken have certainly done a lot to reach such trading volumes. Through aggressive marketing, improvements in user experience, and provision of educational resources, leading CEXs have attracted retail investors—many of whom need an easy alternative for buying and trading cryptocurrencies.

However, the dominance of highly centralized entities may be a threat to the long-term viability of cryptocurrency. For what it’s worth, CEXs are inimical to the true spirit of cryptocurrencies—a means for users to control money without middlemen and its attendant risks.

Signing up for an account on a centralized exchange today requires providing personal information, including email addresses, location, government ID, and home addresses. This is part of the wider attempts to comply with local and international Know-Your-Customer (KYC) and Anti-Money Laundering (AML) regulations.

While CEOs say these rules help protect users from illicit trading or malicious traders, the obvious trade-offs that such KYC/AML procedures encourage are well-documented in articles like this and this. Not only do extensive KYC/AML policies put users’ data at risk, but it also means transactions are anything but anonymous—which just negates the concept of cryptocurrencies.

However, the possibility of Big Brother snooping on user transactions or hackers stealing personal data is perhaps the least thing users of centralized cryptocurrency exchanges have to worry about. With a large amount of funds in their custody, centralized exchanges have become honeypots that thieves (the “bees”, if you prefer) find attractive.

The now-defunct Mt. Gox cryptocurrency exchange was one of the earliest trading platforms to be targeted by crypto-thieves. Based in Japan and founded by Jed McCaleb (who later founded Ripple), Mt. Gox was hacked for more than 740,000 bitcoins valued at over $450 million at the time.

In the years following the infamous Mt. Gox hack, even more exchanges have suffered similar attacks. Bitfinex was hacked for 119,756 BTC in 2016, causing Bitcoin prices to plunge by 30%. A year later, CoinCheck lost BTC valued at $530 million (at the time) in yet another hack attack.

The list of hacked exchanges is longer, but the aforementioned examples show why giving companies ownership of user assets never ends well. Like the Mt. Gox hack revealed, these companies are surprisingly sloppy with security—and users often bear the brunt of these mistakes.

The underhanded practices of many crypto companies also deserves much-needed attention. If we made a Netflix drama about these scandals, it would give Scandal a run for its money.

Cryptocurrency exchange Houbi was infamously accused of using EOS tokens in its custody to vote for select EOS block producers. The EOS blockchain has 21 elected block producers (called Super Validators) responsible for validating on-chain transactions. Of course, the position is super-competitive and highly profitable, which makes the story more interesting.

While Huobi denied the allegations of vote-buying, the whole saga revealed a problem of custodial exchanges—namely, centralized control of user assets. On a crypto exchange, tokens bought and exchanged are not truly “owned” by customers. Through a custody system that gives them access to a user’s private keys, cryptocurrency companies manage the funds hosted on their platforms.

This potentially leaves CEXs with enough leeway to use customer funds however they see fit. Naturally, the lack of regulation means most exchanges can get away without paying interests on customer assets, which is yet another problem.

Exchanges have also been hit with allegations of wash trading in the past. Wash trading is an illegal activity, whereby a group of traders collude to buy commodities on an exchange to drive prices up.

A study published last year found that many exchanges—many of which were centralized—used wash trading to increase profits. By creating buzz around certain coins, exchanges can manipulate prices and make money off retail investors looking to buy the next “hot” coin.

Closely related to wash trading is the spoofing of fake transaction volumes, an act some popular crypto exchanges have been guilty of. Just like wash trading, publishing false transaction volumes gives the illusion that a particular coin is worth buying, which increases trading activity on the platform.

CEXs have even more incentives to give false transaction volumes. For instance, a higher-than-average transaction volume on a cryptocurrency exchange can bolster its stature in the minds of customers. This helps secure the company’s bottom line by way of revenues accrued from fees charged on transactions conducted on its platform.

It’s also interesting to know that many centralized exchanges—despite the volume of funds they hold—remain uninsured. While Gemini, Binance, and a few other exchanges have taken steps to insure user funds, there are more crypto marketplaces operating without any insurance policy to protect customers in event of loss. Nor are they compelled to do so, given crypto’s lack of recognition as government-backed legal tender.

Additionally, it’s important to note that the exchanges mentioned earlier don’t insure the bitcoin, ethereum, or whatever asset the user has in the wallet. Rather, they only insure fiat currencies, such as dollars or euros, held in those wallets.

The whole nine yards of this situation is that users can lose all of their crypto if an exchange suffers a malicious hack. With CEXs getting hacked every other day, the lack of a plan to indemnify users is quite alarming.

The centralization of cryptocurrency exchanges creates single points of failure, which makes service downtimes inevitable. For example, many exchanges including Coinbase and Binance, experienced outages early last year, freezing users out of their accounts.

This is the very problem cryptocurrencies wanted to solve in the first place. Satoshi Nakamoto et al realized depending on banks meant users could be cut off from their funds if banks failed. With CEXs, we’re just having the same problems all over again.

Decentralized exchanges are less prone to service outages since they utilize decentralized servers hosted on different nodes (computers). Such systems are fault-tolerant, so the failure of one node never affects the entire network.

As if restricting users from their accounts wasn’t enough, some exchanges impose withdrawal limits on cryptocurrency accounts. CEX leaders have defended withdrawal limits in the past, saying they are necessary, especially to prevent unverified users from withdrawing large amounts.

However, withdrawal limits can ostensibly benefit a cryptocurrency exchange in other ways. By forcing users to keep assets on the platforms, crypto companies stand to gain more by charging fees on transactions.

Finally, the biggest issue with using centralized trading platforms to store crypto is that users lose control of assets. This is a point mentioned earlier in the article, which we’ll explore in more detail now.

There are two types of centralized exchanges: custodial and non-custodial.

Custodial exchanges retain control of user funds and only make them available when the owner makes a request. Non-custodial exchanges don’t control funds and only serve to match buyers and sellers in true peer-to-peer tradition—their profits come from fees charged on transactions.

So, how do custodial exchanges access user funds? Simple. They keep a copy of a user’s private keys, giving them unfettered access to customer wallets.

A common defense of this practice is that it allows individuals to recover their wallets if they misplace the private keys. Which is a good thing, given how much funds have been lost due to misplaced private keys.

However, the simple rule of cryptographic assets reigns supreme here: “He who has the private keys controls the assets.” If a user doesn’t own the keys to a wallet, they don’t control what happens to it. It’s that simple.

Cryptocurrencies were built on the ideal of complete ownership of and access to one’s funds. Centralized marketplaces have, however, taken this principle and tossed it through the window.

Does this mean we should unilaterally boycott CEXs? Maybe not. Despite their flaws, centralized exchanges still serve their purposes. For example, they make it easier for new traders who may wish to convert fiat money to crypto and vice-versa.

The overarching theme of this piece is that centralized exchanges cannot be the long-term option for the cryptocurrency community—not if the dream of a decentralized monetary framework is to be realized.

While decentralized exchanges need massive improvements in liquidity, user experience, and ease of use, they represent crypto’s best chance of becoming a trustless and decentralized entity, independent of corporate interests.

With adoption growing exponentially, cryptocurrencies are no longer fringe concepts. It’s time to think of the future and stop corporate bigwigs from killing the true ideals of the cryptocurrency movement.