The difference between Centralized and Decentralized Crypto exchanges

The difference between Centralized and Decentralized Crypto exchanges

On 14th July 2022 the Decentralized Exchange called Celsius filed for Chapter 11 Bankruptcy in the US. This sent another shockwave across the Crypto Community, as investors saw their savings become inaccessible or get wiped out.Celsius was one of the largest cryptocurrency lenders, operating a Decentralised Exchange. They had amassed more than $20 billion in assets at their peak. They offered interest rates as high as 18% – 20% to depositors and In June 2022, they halted all withdrawals amid a panic run by clients.In the court filing, Celsius’ Chief Executive Officer Alex Mashinsky disclosed a roughly $1.2 billion hole in the company’s balance sheet. As of July 13, 2022, the company had $5.5 billion in total liabilities and $4.3 billion in assets.In this blog, we will look at what happened, as well as look at the pros and cons of Centralized versus Decentralizsed Crypto Exchanges.

Who were Celsius?

Celsius was is a decentralised lending platform that allowed users to take out loans using their crypto assets as collateral. The team behind the platform built it on the Etheruem Blockchain, using the ERC20 token standard. They launched in July 2017 and quickly became one of the most popular lending platforms in the crypto space

What happened to Celsius?

On March 12th, 2020, Celsius announced that it was suspending all lending and borrowing on it’s platform. In a blog post, Celsius explained that the decision to suspend lending and borrowing was due to “regulatory uncertainty” in the space. The blog post also said that Celsius would be refunding all loans and returning all collateral to borrowers. Many users have reported that they are still waiting for their refunds from Celsius, it looks like it could be a long and uncertain future for those who are seeking to get their investments returned.

This event fuels doubts about the safety of decentralized exchanges and prompts questions about investor safety. Particularly regarding the fact that DEX’s do not have any ability to recover lost, misplaced, or stolen funds. The lack of a KYC (Know Your Customer) process and the ability to cancel transactions generally leads to issues in recovering data or assets.

As with most collapsed businesses, the main issue ws about liquidity.  Specifially, the ability to navigate through the impact of pricing volatiity of the crypto assets of the business and managing the debt ratio.

A catalyst for trouble

One key event linked to the current liquidity crisis in the crypto space was the recent collapse of Three Arrows Capital.

Three Arrows Capital (also known as 3AC), a Singapore-based cryptocurrency hedge fund, was ordered to liquidate on 27 June 2022 by a court in the British Virgin Islands. The company borrowed billions of dollars to fund its trading and now faces $3.5 billion in creditors’ claims according to July 2022 bankruptcy filings. The fund lost over $3 billion dollars over 2021 and 2022, making its collapse one of the largest hedge-fund trading losses of all time. The collapse had a significant impact on the crypto space as many of the exchanges had investment tied into 3AC. This lead to a liquidity squeeze for some. Additionally, the collapse caused further volatility in the pricing of crypto, putting pressure on exchanges with large debts and capital loans to stay in business.

Other DEX problems (Post the Three Arrows Capital collapse)

Celsius was not the only decentralized exchange to fall into problems recently. Recently, Crypto exchange Blockchain.com reportedly gave loans worth $270 million to Three Arrows Capital which now faces problems.
Digital asset brokerage Voyager Digital recently filed for Chapter 11 Bankruptcy protection could not pay back approx $670 million it had borrowed.
U.S.-based crypto lenders Genesis, Blockfi, BitMex and crypto exchange FTX also suffer losses as the dominoes fall fast and hard in the industry where counterparties are closely tied by debt and leverage

The difference between Centralized and Decentralized Crypto exchanges

Let’s look at The difference between Centralized and Decentralized Crypto exchanges

What is a Centralized Exchange

A Centralized cryptocurrency exchange, as the name implies, functions as a middleman between buyers and sellers. Almost all crypto transactions are conducted through centralized exchanges, which provide more trustworthiness.

How Does A Centralized Crypto Exchange Work?

Centralized exchanges are platforms that allow users to buy and sell cryptocurrencies for fiat currencies such as the US dollar or digital assets like BTC and ETH. They operate as trustworthy brokers in deals and frequently serve as custodians, keeping and safeguarding your cash.

Centralized cryptocurrency exchanges include:
– Binance.
– Huobi Global.
– Coinbase (Pro)
– Kraken.
– Bithumb.
– Bitfinex.
– Bitstamp.
– KuCoin.

What are the Pros of Centralized Exchange?
– They tend to have user-friendly interface and simple platforms
– They offer an added layer of security and trustworthiness

What are the Cons Of Centralized Exchange
– Highly vulnerable to hacking or cybersecurity threats
– Charge higher service fees
– Controlled by a centralized entity, and thus can be shut down in theory

What is a Decentralized Exchange

A Decentralized exchange is a non-centralized alternative to a centralized exchange in which no single entity is in charge of the assets. In contrast to traditional centralized exchanges, smart contracts and decentralized apps automate transactions and trades. This method is far safer since no security breach is possible if the smart contract is properly constructed.
Decentralized crypto exchanges vary from centralized crypto exchanges in that they allow users to keep control of their assets by running their important activities on the blockchain.

How do decentralized exchange work?

Decentralized exchanges either run on an AMM (Automated market maker) or traditional order book model.

“In the order book model, a token owner places an order to swap his or her assets for another asset offered on DEX.”. The owner of the token determines the number of units they must sell, the token’s price, and the time limit for accepting bids for the assets.
Other users can offer bids by putting a purchase order after the selling order has been made.
Once the sellers have chosen the time, both sides evaluate and execute all of the offers.

In the AMM Model: Liquidity for an asset and its swap pair are pooled in a smart contract. Those who pool funds are eligible to receive the fees generated from the swaps using this pool.
When someone makes a swap in the pool, the system automatically rebalances the balance of assets in the pool to 50/50 value and the price of the tokens change to reflect the new supply. When a trader makes a large swap in a pool with not enough liquidity, they will run into high slippage issues; meaning the lack of liquidity will result in an above-market purchase price.

Some examples of decentralized cryptocurrency exchanges are :
– 1inch
– Uniswap
– SushiSwap
– Bisq
– IDEX
– Bancor Network

Pros of Decentralized Exchange:
– They cannot be shut down by governments or financial institutions.
– There is no single point of failure.
– The fees are lower than centralized exchanges.
– You are the custodian of your own assets.

Cons of Decentralized Exchange:
– The platforms can be difficult to use for beginners.
– There is less liquidity than centralized exchanges.
– You are responsible for your own security.
– Smart contracts can be hacked.
– The availability of customer support varies.
– It can be challenging to find the right trading pair.

Summary: Liquidity crunch in crypto mirrors traditional markets

What we are seeing now in the crypto ecosystem is that all the lessons learned over the past 100 years in the traditional finance system are playing out. As the ecosystem matures, crypto markets will inevitably become cyclical, just like traditional markets. To weather the downturn, projects must learn from the past. This doesn’t mean crypto loses its edge, just that there are smart principles of sustainability that are applicable to any emerging market.

One of the most important issues in emerging markets is liquidity.  We should rightly be weary of protocols offering high staking rewards on the most mundane activities as this is naturally going to create a run on the system at some point.  

“Innovative projects that apply traditional finance lessons will capture new growth opportunities when the cycle turns again.”

Giant projects like Terra and Celsius going under, tend to have a cascading effect on the broader market.  This is evident from the plummeting prices of most cryptocurrencies recently. We could potentially see further declines and more liquidations as investors forced to sell, and unsustainable projects not equipped to deal with a downturn lose their liquidity.

Not your keys, not your coins

“Not your keys, not your coins” is a popular expression in the world of cryptocurrencies, which refers to needing to own the private keys associated with your funds. “The person who owns private keys decides how the associated crypto assets are spent.” Failing to do so means that we entrust a third party to hold our coins safely for us. Stories like the Celsius one are an eerie reminder that these third parties often do not act in the self-interest of their clients. In my next Blog, we will take a deeper dive into this subject.

Join a community to share and discuss your research, views, and experiences before investing in crypto. As a new investor, it’s a great way to gain insights from others who have walked the path before you. Sign up and join our Crypto College Community to benefit.

Good luck and see you back here again soon!

Jack

 

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