By Amie Parnaby
While the cryptocurrency markets grow, the need for exchanges increases. However, newer exchanges on the market are taking notes from their centralised custodial competitors on how to provide a different type of service. Making non-custodial and decentralised transfers the new wave in cryptocurrency exchange.
The difference between Custodial, Non-custodial and Decentralised Exchanges
There are some significant differences between the three different types of exchange which can be the make or break reasons for choosing one over the other.
Custodial exchanges are the ones you know about, the big names that come up in all of your searches for a crypto exchange; Coinbase, Kraken, Binance, HitBTC, and numerous others. These exchanges require you to deposit your crypto (or fiat in some cases) funds to a non-segregated exchange wallet. When you exchange your crypto coins and tokens most of these trades are made “off-chain” which means the transactions occur only on the exchanges internal ledger, without the confirmation of the blockchain. When your funds are deposited onto the custodial exchange; you lose the complete control of your funds until you remove them from the exchange.
Non-Custodial exchanges do not require you to deposit your funds. You keep sole control of your coins in a hot or cold wallet until you initiate a transaction on the (ex)change platform. Some examples of non-custodial exchanges are Shapeshift, Changelly and Evercoin, with newer ones coming along like Switchain, which compares prices across exchanges to get the best rate, and Terrexa, which facilitates the entry and exit from the crypto space with fiat – crypto and crypto –fiat exchanges available (no crypto –crypto exchange available). Non-custodial exchanges operate much in the same way as an exchange bureau between fiat currencies, you provide one currency (coin) and stipulate the currency (coin) to receive in return, which is then sent directly to a wallet (or bank account) under your control. This almost real-time exchange removes the risk of losing control of your investment through exchange mismanagement or, hacking attempts.
Decentralised exchanges are still in their infancy, but attempting to adhere to the decentralised ethos of the cryptocurrency initiative. The demand for this kind of decentralised exchange is growing. However, so far the volumes available on these exchanges are still low. Some exchanges that you may have heard of are Etherdelta and IDEX. Essentially, these are peer-to-peer transactions with the exchange providing an anonymous ”introductory” service. Trades take place using smart contracts on the Ethereum network, and while trusting a third party with access to your private keys isn’t necessary, you still need to trust the integrity of the smart contract. Ethereum isn’t the only network that supports decentralised exchange, but it is the most prevalent. Some people believe that decentralised exchanges are unhackable, but there have been occasions when money has been stolen from them.
There is a concept of cross-chain atomic swapping, between networks, but so far there hasn’t been a working product that has managed to use this tool for a decentralised exchange platform.
The dangers inherent in custodial exchanges
The reasons for the increased interest in alternative trading solutions are several. The security requirements for centralised exchanges are phenomenal.
As a storage tank for thousands of users cryptocurrencies, they are prime targets on which hackers can justifiably concentrate their efforts for the significant reward at the end. Some of the largest exchanges have been wiped out of the game entirely by dedicated hacking attacks that resulted in the loss of millions in Bitcoin and altcoin fortunes. Mt.Gox is one with which you are probably familiar, once the biggest exchange in the industry, it was all but destroyed by the loss of approximately 850,000 Bitcoin (at the time worth around $450million).
The off-chain nature of the centralised exchange model is cause for concern when it comes down to the transparency of transactions for things such a tax and income reporting.
The large, centralised exchanges are primarily the only places where you can cash out your cryptocurrency for your local fiat equivalent (or at least USD). As such, they have been made subject to the stringent and highly intrusive measures required by traditional financial institutions; there goes any chance of anonymity in trading cryptocurrency.
The vast amount of control that can be exerted over deposited funds can be worrying to some investors and traders. There is also the potential concern that some of these large, centralised exchanges aren’t fully collateralised in case of systems failure, to compensate their clients. In a primarily unregulated sphere, the customer protections that exist in fiat and securities markets aren’t there.
Finally, as another potential problem to come from the unregulated status of the digital currency market, there are no measures in place to inhibit large exchanges from manipulating the markets when they are in possession of inside information. In traditional financial spheres, there are controls and laws in place to make this kind of market manipulation illegal.
Why would non-custodial and decentralised exchanges be better?
It is not always the case that they are. It may be that you want access to large pools of a particular coin or trade your bitcoin for fiat. Depending on your location, a centralised exchange may be your only option. However, there are restrictions in the centralised exchange space just as anywhere else.
Access to small and unlisted coins may cause problems on an extensive exchange that hasn’t decided to list an obscure token. You are more likely to find access to small pools of unknown and new coins on a decentralised exchange.
Non-custodial exchanges that don’t have a fiat trading option have less bureaucratic red-tape to wade through when it comes to listing new coins. Although
You may not like the idea of handing over control of your holdings to a third party.
Which one should you use?
At present, there is no catch-all exchange solution to cryptocurrency trading. Whichever exchange type you use, it is worth doing your own research (DYOR is such a ubiquitous acronym in crypto circles) dependant on your trading or investing strategy or style.
If you want to quickly and easily trade coin again coin in quick succession, you may not have a choice but to use a centralised exchange for your needs. You will need to be aware of the risks and make a regular withdrawal off the exchange.
If you want to slowly build a portfolio of cryptocurrencies, with no desire to trade, then a non-custodial exchange could be great for you.
If your interest lies in small, low volume, and obscure coins in which you make small trades against Satoshi, then your best bet will probably be the decentralised exchanges.
There is no definitive “correct” choice.
However, it is worth noting that the desire for alternative exchange solutions is increasing. The need and desire for such alternates will drive them to greater adoption. Greater control over your holdings, more transparent trading, greater reach over the range of coins available; there are abundant reasons why traders and investors want to change the way they are doing business.
The future may be a little less profitable for the centralised exchanges if as David Lee, author of the Handbook of Digital Currency, asserts that decentralised exchanges will become the main avenue for crypto trading in the next five to ten years. Although, the centralised exchange may yet be saved by a change in role, perhaps becoming the cryptocurrency central banks of a crypto-adopted financial future.
About the Author:
Amie Parnaby is a professional writer and her experience spans a broad range of industries, from I.T. to training and optics to banking. Currently, Amie is the content writer for Terrexa – your entry point for crypto.
