Centralized and decentralized exchanges, AKA custodial and non-custodial exchanges
All major cryptocurrency exchanges at present are centralized exchanges (CEXes). They are not built on decentralized blockchain infrastructure but instead represent blockchain-based assets within an internal database that only they control.
When you buy Bitcoin on a centralized exchange, you are buying a representation of Bitcoin within the exchange’s database. You only come to own actual Bitcoin when you withdraw it from the exchange’s wallet to a wallet whose private key you control. Until that point, the exchange has custody of your Bitcoin – and you are trusting them to keep it safe.
This centralized, custodial system has certain advantages. Since blockchains’ speed is limited by the rate at which blocks are added to the chain, implementing a high-performance matching engine purely on a blockchain is impossible. Furthermore, blockchains are not compatible with each other (Ethereum cannot “talk” directly to Bitcoin), which means that some intermediary system is required to trade assets across chains.
Centralized exchanges represent an easy way of bringing Forex-like trading to digital assets. However, they undermine the fundamental principle of digital assets – decentralization and trustlessness – which is ultimately where these assets derive their value.
As trusted parties, centralized exchanges are targets for hackers and huge amounts of money continue to be stolen, even from some of the largest, most established exchanges. What’s more, they remain totally non-transparent and there is evidence to believe that manipulation occurs within their matching engines.
Decentralized exchanges (DEXes), by contrast, are built using blockchain infrastructure. A genuine decentralized exchange will be non-custodial, never taking control of users’ assets and allowing them to trade directly from a wallet they control.
Owing to the limitations of building directly on blockchains, existing decentralized exchanges exhibit much poorer performance and user interfaces than centralized exchanges, hence their relative unpopularity. They are harder to use and have difficulties solving front-running problems. DEXes are also unable to offer trading across chains without some form of custodial solution, e.g. “wrapping” a token by creating a representation of it on another, compatible chain. During this time, the original tokens remain with a custodian.
Nash aims to change this. We have developed a non-custodial, decentralized exchange that makes use of an off-chain matching engine to achieve competitive performance, including cross-chain trading.
For more detailed information on these issues, you can read our article about the different types of cryptocurrency exchange.