Understanding the Structure of Cryptocurrency Exchanges

by Heybit
Understanding the Structure of Cryptocurrency Exchanges

Basic Structure of Centralized Exchanges

A cryptocurrency exchange refers to a platform where cryptocurrencies like Bitcoin and Ethereum can be exchanged for fiat currencies or other cryptocurrencies. Unlike stock exchanges, cryptocurrency exchanges operate 24 hours a day, 365 days a year, allowing for constant trading of cryptocurrencies over the internet. Cryptocurrency exchanges also store the cryptocurrencies used in trades.

Recently, cryptocurrency exchanges have been offering various services beyond brokering, such as financial products like staking and depositing, cryptocurrency loans, and NFT marketplaces. They also provide professional services targeting not only individual users but also institutions.

Therefore, a cryptocurrency exchange is an essential platform for those who want to invest in cryptocurrencies or exchange their holdings for other cryptocurrencies. Cryptocurrency exchanges can be categorized into centralized exchanges (CEX), where a centralized entity manages intermediary services and listings, and decentralized exchanges (DEX) which operate in a decentralized manner.

Well-known centralized exchanges, such as Upbit and Bithumb, are widely used due to their ease of use and reduced hassles. The convenience of centralized exchanges is a major factor that attracts many investors. However, centralized exchanges also have several disadvantages.

Traditional stock trading has distributed authority and functions, whereas cryptocurrency exchanges manage all functions. In other words, they handle the circulation, listing, settlement, and custody of cryptocurrencies. As a result, this structure can lead to controversies related to listings and chronic issues such as misappropriation and embezzlement of customer funds, as well as the exploitation of insider information.

Major centralized cryptocurrency exchanges include Upbit and Bithumb in South Korea, and Binance and Coinbase internationally.

Centralized Exchanges vs. Decentralized Exchanges

Unlike centralized exchanges, decentralized exchanges do not involve a centralized entity in the trading process. In other words, they support peer-to-peer (P2P) transactions, allowing trades to be conducted without an intermediary. Transactions are processed instantly by the system, and the trading costs are lower compared to centralized exchanges.

Decentralized exchanges also offer higher transparency since there is no centralized entity holding or managing cryptocurrencies, which frees them from centralized issues. In a nutshell, individuals store all cryptocurrencies and conduct P2P transactions without the involvement of a third party.

However, the biggest drawback of decentralized exchanges is their complexity and difficulty for beginners. There are basic requirements (such as specific cryptocurrencies and wallets) to use decentralized exchanges, and currently, all decentralized exchanges are provided in English.

As a result, investors who prefer a simple trading process find it difficult to use decentralized exchanges. Moreover, since decentralized exchanges require users to store their cryptocurrencies directly, users must create and manage separate wallets. Consequently, the lower convenience and trading speed compared to centralized exchanges are pointed out as issues.

Examples of major decentralized exchanges include Uniswap, PancakeSwap, and Curve Finance.

The Future of Cryptocurrency Exchanges

The bankruptcy of the FTX exchange in November last year has sounded the alarm for cryptocurrency exchanges. Financial records manipulated by centralized entities, misappropriation of customer funds, and hacking incidents are inherent issues of centralization. Due to these problems, the risks for domestic and global exchanges are indeed increasing.

In the future, centralized exchanges are likely to be required to disclose their financial structures transparently or undergo mandatory accounting audits by third parties. Additionally, it is expected that countries will establish regulations to protect investors in cryptocurrency exchanges at a national level.

Although decentralized exchanges are gaining attention, centralized exchanges' advantages and roles are evident, so they are not expected to be easily replaced. Therefore, it is essential to understand the structure, advantages, and disadvantages of cryptocurrency exchanges to protect one's assets and invest wisely.