To understand the essentials of buying and selling cryptocurrency, it's crucial to grasp the two primary types of crypto exchanges: centralized and decentralized. Both are integral to the crypto economy, offering unique advantages, drawbacks, and features. Their primary role is to facilitate the exchange of fiat currencies like dollars or euros for cryptocurrencies, enhancing accessibility and ease of use for newcomers to the crypto world. This time, we’ll be looking at centralized exchanges (CEXs).
Centralized cryptocurrency exchanges can most simply be thought of as similar to a stock exchange like the New York Stock Exchange or Nasdaq. As retail customers who want to buy or sell stocks, we would then get an account with a brokerage. However, in crypto trading, it's akin to opening an account directly with the exchange itself, such as Coinbase or Binance. And just like with the process of opening a stock brokerage account, the crypto CEX process also has similarities with identification, linking your bank to fund your account, etc.
A CEX is run by a single organization, acting as a middleman in transactions between buyers and sellers. This entity provides liquidity for the supported tokens and uses an order book system to determine crypto prices, similar to traditional financial markets. Users deposit funds into an account on the exchange, which then takes on the role of a custodian.
The centralized nature of these exchanges allows for quick decision-making and efficient service provision, including advanced trading tools, support for fiat currencies, streamlined account management, and customer support. This results in higher trading volumes and increased liquidity, leading to faster trade execution and more competitive pricing. Moreover, the crypto is held by the exchange (i.e., the custodian role mentioned above) so most of the time, when you are trading a cryptocurrency, such as bitcoin, it will not physically move into your wallet/account. The move is simply accounted for in the CEX database and will be moved to you later, most likely when you withdraw your funds. Otherwise, the speed of execution would be impossible if you are using the blockchain’s native way of transferring funds.
The mechanism of how trades work is an order book system for facilitating crypto trading. This electronic list displays all buy and sell orders, indicating the price and quantity of each order, and reflects ongoing trading activity. Users place orders on the CEX, and when a compatible price is found, the exchange matches these orders and executes the trade, typically for a fee. Again, this is very similar to a normal stock brokerage account.
Overall, there are significant benefits to using CEXs, including user-friendly interfaces, a broad range of supported cryptocurrencies, and higher liquidity compared to decentralized exchanges. The liquidity, crucial for quick transactions at stable prices, is bolstered by their access to a large pool of buyers and sellers, as well as regulated market makers.
However, being governed by a single entity also presents risks, such as potential mismanagement of funds, susceptibility to regulatory actions, and the risk of front-running or market manipulation. Moreover, the centralized management often means a lack of transparency regarding the exchange's operating principles, as we have seen with FTX.
Security Measures and KYC Requirements in CEXs
Centralized exchanges employ various security measures like passwords, two-factor authentication (2FA), cold storage, withdrawal restrictions, and regular audits. Despite this, they generally require users to utilize their custodial wallets, meaning the exchange holds the private key, and users merely have access to these wallets.
Acknowledging the risks associated with this arrangement, some CEXs have advised users to transfer their funds to non-custodial wallets post-purchase. This recommendation underscores the importance of managing one's funds independently.
Additionally, CEXs mandate official identity verification (KYC) due to their status as regulated businesses. This process compromises user privacy, as sensitive information must be shared with the centralized authority. Crypto often gets touted as a medium that offers privacy, but if you use a CEX, then your identity is at least exposed to the exchange.
Conclusion
Centralized Exchanges (CEXs) provide speed, liquidity, and a friendly user interface at the cost of trust/counterparty risk of the exchange and privacy. Therefore, CEXs play a central role in the robustness of the overall cryptocurrency markets, the same way stock exchanges do in traditional financial markets.