Centralized exchanges and their risks – 2Ether

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The ecosystem of 2Ether will include a decentralized exchange, 2EtherEx. How are decentralized exchanges — DEX — different from traditional centralized exchanges? Are they really better? What issues do they face? We’ll tell you all about it a series of posts. This time, we’ll look at centralized exchanges — why they have nothing to do with real decentralization and what risks they pose.

Big exchanges like Coinbase and Huobi allow you to trade in decentralized crypto assets, but they themselves are completely centralized. This is for three reasons:

1) All transactions are processed off-chain and recorded in the exchange’s own database. All those thousands of trades made every day on Coinbase, for example, are never recorded on the blockchain.

2) Client funds are stored in a centralized way. When you deposit money on an exchange, it goes into the main wallet of the exchange. It’s huge — there are millions of dollars’ worth of crypto there. If you send money from your blockchain wallet, then this — and only this — operation is recorded on the blockchain. After this, the centralized exchange assigns you credit of sorts — it puts as much crypto on your individual account as you put in the main wallet. At the end of trading, when you want to withdraw your profits, you sort of exchange those credits for the real crypto, which gets sent to your wallet. This transaction is also recorded on the blockchain. But everything in between has nothing to do with decentralization.

3) The exchange management is centralized — it’s in the hands of a few people. They can become very powerful, and their decisions influence what happens to your funds. For example, Changpeng Zhao, the CEO of Binance, has such weight in the industry that he doesn’t even comment on the potential of any coins. On the other hand, illegal actions taken by exchange executives can have terrible consequences. When the CEO of the Canadian exchange Quadriga was found dead in India, it turned out that almost $100 million were missing from the accounts. This money will probably never be found.

Centralization of exchanges has several more risks:

– Easy target for hackers. We’ve all heard about massive thefts from exchanges — sometimes up to $500 million. Since all the funds are stored together, exchanges’ wallets are among the most attractive things to hack, so criminals keep trying.

– Market manipulations. Exchanges and their partners do lots of wash trading, fictitious deals, front-running, etc. It’s estimated that over 80% of all Bitcoin trading volume is essentially fake. Exchanges want to be in the top-10 by volume — and most of their revenue comes from commissions. So they will allow bots and many dubious practices, even if their Terms of Use usually say that you can’t manipulate the market in any way.

– Arbitrary actions. An exchange can suddenly close operations in a certain country, introduce an obligatory KYC, or delist an asset.

So if centralized exchanges are so risky, why do most traders use them? The reason is that they have some very serious advantages, too. We’ll look at those advantages in our next post.

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