Today there are thousands of cryptocurrencies out there. Technically, each cryptocurrency is tied to its native blockchain which records the transaction history. While it is easy and secure to transact cryptocurrencies within the same blockchain, it is more complicated and less secure to do so across different blockchains due to the lack of an inter-chain trading mechanism.
Thus was born centralized crypto exchanges. In essence, a user who deposits digital assets into a centralized exchange gets back an “I Owe You” (IOU) from the exchange acknowledging that it owes the user the actual assets represented by the IOUs.
IOUs are an efficient and effective tool for trading cryptocurrencies, compared with transacting across two distinct blockchains. Within a single environment controlled by the exchange owner, the IOU exchange process is fast, simple, and user friendly. As the exchange aggregates a large group of users, liquidity and trading pairs gradually ramp up. As the exchange achieves scale and automation, it allows for sizable profits through the levy of trading fees. This in turn funds better user interface and business development to attract even more users and trading volumes, turning this into a virtuous cycle.
However, this centralized model carries a number of significant risks for both the user and the exchange. First, the user hands over control of cryptocurrencies’ private keys to the exchange, which stores them on a database. Since the database must be connected to the internet, it is constantly exposed to hacking risks. In addition, because of the large number of users, the database represents a valuable target and attracts the most sophisticated attackers. When a breach occurs, there is effectively no means to recover the funds stolen from a centralized exchange.
Because of the high risk and enormous liabilities, centralized exchanges often find it difficult to find an insurance provider, leaving users unprotected. Of course, the exchange owner must also face the risk of theft even from among their own employees.
Therefore, it remains to be seen whether the centralized exchange model can remain viable in the future. In fact, many decentralized exchanges have emerged, and many well established centralized exchanges are adopting decentralized technologies. In the next article, we will introduce decentralized exchanges in detail.
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