In the cryptocurrency ecosystem, centralized exchanges are arguably the most fragile piece of infrastructure. These exchanges regularly make the news for their failures— they’ve been hacked, issued fake money, and have become insolvent, among other serious failures.
Centralized exchanges have many problems:
1. Counterparty risk : Users must actually send their cryptoassets to the exchange. Upon receipt, the exchange will credit the user’s account on its own internal ledger. Centralized exchanges maintain private, internal books. Some have been found to have been running fractional reserves and subsequently have gone insolvent. Others are suspected of market manipulation and front-running their customers.
2. Speed : To minimize counterparty risk, users must withdraw their cryptoassets when they have finished trading. This is a slow process, especially if the user hits withdrawal limits imposed by the exchange.
3. Regulatory risk : Centralized exchanges are subject to local regulations. This can lead to delisting of assets and issues with liquidity that may affect prices. Exchanges may also be shut down by regulators and have customer assets seized.
4. Attack risk : Exchanges take complete control of users’ funds and keep them in a limited number of wallet addresses, thus becoming prime targets for hackers.
5. Cost : Trading fees in crypto are an order of magnitude higher than those of equity exchanges. For example, Bittrex (one of the largest exchanges by volume) charges 0.25% on each trade for both market makers and takers .
The number of centralized cryptoasset exchanges that have been compromised is too large to list in its entirety. The most notable, Mt. Gox, lost 850,000 BTC , worth $450 million at the time (over $5B today), in a hack or potential inside job that sent shockwaves through the entire industry. Bitfinex, another exchange, lost $65 million in a 2016 hack. Cryptsy shut down after being hacked in 2016. These events have become so common that they are actually expected.
The #1 rule of crypto is: “Never leave your tokens on an exchange.”
While users know they are at risk every time they use an exchange, they continue to do so because the exchanges are a necessary piece of infrastructure for trading. While users can mitigate risk by immediately withdrawing cryptoassets after trading, the process is still insecure. Customers of various exchanges often report issues and time delays when withdrawing, leading to rumors of exchange insolvency. Be-careful out there.