Decentralized vs Centralized Bitcoin Exchange — Can they co-exist?
By: Mary Ann Callahan
Tags: Bitcoin Exchange, Cryptocurrency, Centralized Exchange, Bitcoin, Decentralized Exchange

Since the very beginning of the discussion about Bitcoin, proponents have touted the fact it is an innovative currency and how that makes it better than its alternatives. The largest advancement afforded by Bitcoin is the level of decentralization it provides. But is Bitcoin and the management of Bitcoin really all that decentralized?

Is Bitcoin Really Decentralized?

The general conditions to define if a project is decentralized are censorship-resistance and immunity to authoritarian modifications. As a whole, the protocol does seem to fulfil both of these conditions, but when you start to examine its day-to-day use in the market, it becomes easier to question this status.

Satoshi Nakamoto created Bitcoin, but has faded into the shadows and decidedly not exercised any power over Bitcoin; governments and regulators have not taken and likely will not be able to take any control of Bitcoin movement within its Blockchain as well. However, there are companies like cryptocurrency exchanges that act as middlemen when transacting Bitcoin.

The Bitcoin exchange can be centralized or decentralized. Let’s look into advantages and disadvantages of each type and compare them.

Centralized Exchanges

Pros

The first thing to realize is that each centralized trading platform is providing a wider diversity of services, but takes away a certain freedom at the same time, and it can be viewed as both positive and negative feature. This is all by your purpose.

Centralized Bitcoin exchanges hold the cryptocurrencies in custody to make it easier to trade them. This is a benefit that many users relish, and they also like that they don’t have the responsibility to worry about the safety of their cryptocurrency.

Wallet balances are automatically adjusted to reflect changes in the crypto market, and when Bitcoin went through SegWit, these exchanges retained custody and executed the split on their own. This is a clear gain for the users who would not have the time or expertise to figure out how to handle this split on their own.

Another big advantage of centralized exchanges is the prices they enable for customers. Since they are able to aggregate so many orders at once and don’t have to deal with some of the more complicated custody issues, they can provide the same service at a cheaper cost.

Cons

For many people, convenience and cost are strong enough benefits to justify the continued use of centralized exchanges, but there are also risks involved.

The largest risk, and one that many have highlighted in recent times, is the chance your cryptocurrency will be confiscated or compromised. Even if the centralized exchange doesn’t act in explicit bad faith, their entire network is set up like a honeypot that just serves to motivate hackers.

Another issue that may present itself is the problem of leadership making decisions that affect the fate of your Bitcoin. For example, when Coinbase made the decision to trade Bitcoin Cash, that caused a huge stir in the market, and wasn’t a democratically arrived-at decision. This seems to be very similar to the setbacks of regular fiat currencies, which is where the criticism comes in.

How Centralized Exchanges Compare with Decentralized Ones

On the most basic level, the big difference between centralized and decentralized exchanges are that centralized exchanges don’t fit with the intent of the blockchain community. The entry and exit points to the blockchain have fees and gatekeepers, which is not the libertarian paradise blockchain enthusiasts have been dreaming of.

Examining that further, decentralized exchanges can only convert cryptocurrencies, whereas centralized exchanges can convert crypto to fiat and vice versa, provide a trading platform for different pairs, ensure automated and margin trading, etc. This is a matter of the current know your customer (KYC) regulations in place and indicates a significant weakness in the utility of decentralized exchanges.

Security and reliability are a major plus for decentralized exchanges. They run on hundreds of nodes, which means no downtime and a tightly protected storage for your private keys. When Mt. Gox crashed, that was a major sign that centralized exchanges had a weakness as the private keys weren’t 100% safe in their custody. It resulted in the biggest Bitcoin theft so far — over $450 million in Bitcoin was stolen overnight. Though, it would be fair to note that many changes have taken place since then (2014), and modern centralized exchanges try to use reasonable precautions to keep users’ funds safe — cold storage, multisignature, two-factor authentication, etc.

Liquidity is generally thought to be worse on decentralized exchanges right now, because they don’t have nearly as many market-makers, although they do route orders and information through a peer-to-peer protocol in a manner that is more scalable.

On the other hand, decentralized exchanges are generally more expensive and complicated to use right now. User interface isn’t amazing, and they are more of an intellectual accomplishment than a perfect tool. So far, a lot has to change before they can properly compete with centralized exchanges. Perhaps, this is why centralized exchanges are still prevailing in the market.

However, with the technology rapidly evolving and new solutions arriving, a shift in user preferences might be instantaneous.

Does it Matter?

The thing we are all wondering here is whether any of this matters. Decentralization is a good thing, but there are a ton of other benefits that make it an innovative digital currency. For example, there is the trustless aspect of it, where it is impossible for a user to renege on a transaction. And there is also the ledger that effectively solves the double spending problem.

So, should any of us care if Bitcoin is being decentralized or not? It really depends on why you are investing in Bitcoin. If you are doing it because you think digital currencies are the future and believe in any currency that isn’t managed by the Federal Reserve, then you are still in the clear and can continue using centralized exchanges. However, if decentralization was your main reason for investing in or trading Bitcoin over other options, then you are clearly putting yourself in a quandary and need to re-examine your investment thesis.