For most digital currency investors, the centralized cryptocurrency exchange is one of the most important vehicles for transacting. Centralized cryptocurrency exchanges are online platforms used to buy and sell cryptocurrencies. They are the most common means that investors use to buy and sell cryptocurrency holdings.
Some investors may find the concept of a "centralized" exchange to be somewhat misleading, as digital currencies themselves are often billed as "decentralized." What does it mean for an exchange of this type to be "centralized," and why are these exchanges so crucial for the success of the cryptocurrency industry as a whole?
Use of Third Parties
In the term "centralized cryptocurrency exchange," the idea of centralization refers to the use of a middle man or third party to help conduct transactions. Buyers and sellers alike trust this middle man to handle their assets. This is common in a bank setup, where a customer trusts the bank to hold his or her money.
The reason for this setup is that banks offer security and monitoring that an individual cannot accomplish on his or her own. In the case of a centralized cryptocurrency exchange, the same principle applies. Transactors trust not only that the exchange will safely complete their transactions for them, and they also make use of the network of users in the exchange in order to find trading partners.
In the case of cryptocurrencies, which are often stored in digital wallets, an individual can lose hundreds or thousands of dollars in digital currency holdings simply by forgetting the key to a wallet. An exchange will not allow this to happen, as it safeguards the holdings in place of the individual investor.
Differences Between Centralized and Decentralized Exchanges
Centralized exchanges can be used to conduct trades from fiat-to-cryptocurrency (or vice versa). They can also be used to conduct trades between two different cryptocurrencies. While this may seem to cover all of the potential transaction types, there is still a market for another type of cryptocurrency exchange as well.
Decentralized exchanges are an alternative; they cut out the middle man, generating what is often thought of as a "trustless" environment. These types of exchanges function as peer-to-peer exchanges. Assets are never held by an escrow service, and transactions are done entirely based on smart contracts and atomic swaps. (See more: What Are Decentralized Cryptocurrency Exchanges?)
The crucial difference between centralized and decentralized exchanges is whether or not a middle man is present. Decentralized exchanges are less widespread and less popular as compared with centralized exchanges. Nonetheless, there are more decentralized exchanges all the time, and it's possible that they will give centralized exchanges a run for their money in the future.
It's more common for a centralized exchange to offer cryptocurrency/cryptocurrency pairing at this point. This would allow customers to trade, for instance, bitcoin for ether tokens. Fewer exchanges offer fiat currency/cryptocurrency pairs, which would allow, say, bitcoin for USD exchanges.
Some of the largest cryptocurrency exchanges in the world are those that offer these fiat/cryptocurrency pairs, however. Part of the reason for this is likely that they serve as a direct access point to the cryptocurrency market.
Since many investors in the space are relatively new to investing in digital currencies, they may be more likely to turn to these types of exchanges. Some of these exchanges include Coinbase, Robinhood, Kraken, and Gemini. (See more: All about Gemini, the Winklevoss Bitcoin Exchange.)
Key Elements of Centralized Exchanges
There are new centralized cryptocurrency exchanges all the time. However, not all of them will be successful, and it's not uncommon for these exchanges to fold. The success or failure of an exchange is dependent upon a large number of factors. However, one of the key components to success is trading volume.
Generally speaking, the higher the levels of trading volume, the lower the volatility and market manipulation that's likely to take place on that exchange. Volatility is a crucial consideration. Because of the time it takes for transactions to be completed, the price of a given token or coin can change between the time the transaction is initiated and the time it is finished. The higher the trade volume and the faster the transaction can be processed, the less likely this fluctuation is to be problem.
Another crucial element of a successful centralized exchange is security. While no exchange is completely immune to malicious activity like hacks, some are safer than others. (See also: CoinDash: Ethereum Hacker Returned 20,000 Stolen Ether Worth $17M.)
The way an exchange reacts to an event such as a hack is by no means a given. Some exchanges have worked hard to refund customer losses, while others have been less successful in that regard. Still others have shuttered as a result of these types of attacks. (See more: Bitcoin Mass Hysteria: The Disaster that Brought Down Mt. Gox.)
For investors looking to enter the cryptocurrency space, a centralized exchange is still the most common means of doing so. When selecting an exchange, it's important to keep in mind the host of factors which will impact user experience, including which pairs are traded, how high trading volume is, and the security measures exchanges have adopted to protect their customers.
Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns bitcoin and ripple.