What Are Centralized Cryptocurrency Exchanges?

What Are Centralized Cryptocurrency Exchanges?

Centralized cryptocurrency exchanges are online platforms used to buy and sell cryptocurrencies. They are the most common means investors use to buy and sell cryptocurrency holdings. For most digital currency investors, the centralized cryptocurrency exchange is one of the most important vehicles for transacting.

Some investors may find the concept of a "centralized" exchange somewhat misleading, as digital currencies are often billed as "decentralized." Here's what it means for an exchange of this type to be "centralized" and why these exchanges are so crucial for the success of the cryptocurrency industry as a whole.

Understanding Centralized Crypto Exchanges

In the term "centralized cryptocurrency exchange," the idea of centralization refers to using an intermediary or third party to help conduct transactions. Buyers and sellers alike trust this entity to handle their assets. This is common in a bank setup, where a customer trusts the bank to hold their money.

The reason for this setup is that banks offer security and monitoring that an individual cannot accomplish on their 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 but also that it will use the network of users in the exchange 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 attempts to safeguard the holdings for the individual investor.

Key Elements of Centralized Crypto Exchanges

New centralized cryptocurrency exchanges are emerging all the time. However, not all of them are successful—it's not uncommon for them 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 likely to occur 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 will be a problem.

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.

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 that will impact user experience, including which pairs are traded, how high the trading volume is, and the security measures exchanges have adopted to protect their customers.

Centralized vs. 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 intermediary, 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.

The crucial difference between centralized and decentralized exchanges is whether or not a third party is present. Decentralized exchanges are less widespread and popular compared with centralized exchanges, at least in the U.S. (due to regulatory issues). Nonetheless, it's possible that they will give centralized exchanges a run for their money in the future.

Fiat/Cryptocurrency Pairs

It's common for a centralized exchange to offer cryptocurrency/cryptocurrency pairing. This allows customers to trade, for instance, bitcoin for ether tokens. Fewer exchanges offer fiat currency/cryptocurrency pairs, which would allow crypto trades for regular currency exchanges.

Some of the largest centralized cryptocurrency exchanges in the world offer these fiat/cryptocurrency pairs; however, most are not regulated. Part of the reason for this is likely that they serve as a direct access point to the global cryptocurrency market and don't have an established presence in the U.S.

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.

The Bottom Line

Centralized cryptocurrency exchanges are online trading platforms that facilitate cryptocurrency exchanges between customers who prefer a familiar trading environment. These platforms are often used to store cryptocurrency and expose traders and investors to assets that are otherwise difficult for many people to access.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read our warranty and liability disclaimer for more info. As of the date this article was written, the author owns bitcoin and XRP.