At the very beginning of crypto’s brief life, large-scale trading was almost impossible. Old-school cyberpunks convened in dark alleys to swap public Bitcoin addresses written in longhand on paper wallets; trading posts were primitive and difficult to use.
And then came centralized crypto exchanges, which were able to bridge the gap between the fiat and crypto worlds, with easy-to-use interfaces and purportedly solid connections to the banking world.
Over time, however, a handful of these exchanges, among them Binance and Coinbase, began to control the lion’s share of the crypto trading market. For instance, in January 2023, Binance’s monthly trading volume stood at $474.11 billion.
Before its almost overnight demise, FTX also dominated the market with a trading volume of $54.12 billion in September 2022. The fall of FTX left millions of investors locked out of assets, creating a crisis of trust in the industry and pushing investors to finally start taking the “not your coins, not your crypto” phrase seriously.
While the FTX crash continues to serve as a cautionary tale, crypto enthusiasts have long hated centralized exchanges. Take Ethereum cofounder Vitalik Buterin, for instance. In 2018, Buterin said he wished centralized exchanges would “go burn in hell”—a tad dramatic, but he had his reasons. He reiterated that “anything centralized is suspect” in 2022.
Despite the ease and convenience that centralized exchanges provide, critics argue that they create a barrier to the transparency that blockchain was supposed to usher in. They hold assets for millions of users across the world, and use market markers and centralized order books to log trades.
Doesn’t that sound similar to banks logging transactions on a private ledger—the very thing blockchain was designed to avoid?
Let’s take a dive into what makes these gigantic crypto exchanges so controversial.
Your Assets Are My Assets
When you want to trade on custodial centralized exchanges, you have to trust the exchanges to keep your assets safe. The problem is that doing so leaves your assets exposed in the event of a hack or mismanagement by the exchange’s owners. Even the biggest and seemingly safest exchanges get attacked—Binance lost nearly $500 million in an attack in October 2022.
But it’s not just cyber security issues that can threaten your funds on an exchange. If the exchange faces a bank run like FTX did, or if it goes bankrupt due to liquidity issues, you’re in for a long and painful wait with no guarantee you’ll get any of your funds back.
Indeed, crypto exchanges are at best patchily regulated. The more respectable exchanges, including Coinbase, enforce anti-money laundering and know-your-customer provisions. However, many exchanges, especially those whose services are more legally dubious, maintain headquarters offshore and rely on underground “shadow banks” to onboard and offboard assets. Neither is there the federal deposit insurance that fiat banks have—and even if you think your funds are safe with one exchange, they may be at risk when another fails, as was discovered during the domino-like collapses of 2022.
The SEC, for instance, is (as of the time of writing) looking into internal transactions between the now-defunct Genesis exchange and its parent, Digital Currency Group. Genesis was exposed to the collapsed exchange FTX, which had itself lent billions of dollars of user assets to sister firm Alameda Research.
Many crypto firms lend to and borrow from each other—one push and they go down like dominoes.
We Got You Covered With Reserves (Maybe)
Until 2022, most crypto exchanges simply said they had the reserves to back up your assets and you had to trust them. But with a crisis of trust after the FTX collapse, blind trust without proof was no longer an option.
Most exchanges resorted to providing proof that their wallets backed their words when it came to reserves.
Binance published its first proof of reserves in late October 2022 and the trend quickly caught on. As funds started flowing out of exchanges, top exchanges like OKX, KuCoin, and Huobi also started providing periodic proof of their reserves to gain user trust.
CryptoQuant even started tracking how “clean” exchange reserves are, which reflects the liquidity of an exchange or its ability to pay back users. An exchange’s reserves are 100% clean if no part of their reserves is held in their native tokens.
But these proofs of reserves are a long way from being perfect, and critics have called for professional audits. Binance improved its own proof of reserves system to include zero-knowledge verifications on Feb. 10, 2023, but there’s still a long road ahead. But the fact that exchanges have started working on providing proof is a bright sign.
Your Data Is (Probably) Safe With Us
Centralized exchanges edge uncomfortably close to Web2 companies when it comes to user data. They collect a plethora of user data, from your address and phone number to IDs and banking details. And they share these data with other parties that help keep the show running.
In 2019, Coinbase received flak for acquiring blockchain analysis firm Neutrino, which some claimed had sold spyware to authoritarian governments. In 2020, Coinbase CEO Brian Armstrong admitted that the exchange had “messed up.”
However, even some decentralized exchanges have admitted to tracking user data—albeit via centralized front-ends.
We (Don’t Always) Vet Tokens Before Listing
Centralized exchanges have also been known to recklessly list buzzy tokens, even if they aren’t the best quality. Huobi, for instance, listed a token in 2022 that hadn’t been authorized by its issuer for listing—that is, it was entirely fake. Other exchanges, meanwhile, have been known to delist tokens—and harm investors—at the whim of company officials. One example: the mass delisting of the “Bitcoin Satoshi Vision” coin after its founder started suing crypto grandees.
Coinbase, by contrast, used to be known for its heavily curated selection of tokens—until 2019, when the company began listing hundreds of small-cap “altcoins” as the market grew frothy. The SEC has implied that some of these altcoins may have been illegal securities, and while Coinbase denied the charges, it subsequently delisted a large number of them.
A Necessary Evil?
Using centralized exchanges requires trusting them on multiple fronts, often without much verifiable proof. This, the critics say, goes against the ethos of trustlessness that blockchains stand for. Nevertheless, they are a crucial part of the ecosystem and are responsible for billions of dollars in trading volume. They may have their problems, but they’re not going away.
But regulators also have a big part to play. Regulating crypto exchanges can help ensure the firms toe the line and make user protection their priority, weeding out fraud. Still, the “regulation through enforcement” approach hasn’t earned regulators any brownie points from investors or exchanges.