What Are Custodial And Non-Custodial Crypto Exchanges?
Cryptocurrency exchanges are one of the key elements that underpin the crypto industry. Without them, we would not be able to determine the price of cryptocurrencies. Cryptocurrency exchanges technically can be of two types: custodial and non-custodial. Custodial exchanges hold their users’ funds, non-custodial crypto exchanges do not. But how that happens is a complex story with multiple intricacies hidden inside.
What Are Custodial Crypto Exchanges And How Do They Work?
Custodial exchanges work on the technical base of data centers, on servers, switches, routers, etc. The processing capacities of such systems far exceed the operational capabilities of blockchains, which are often limited by their consensus algorithms and the need to prevent fraudulence in the network. Centrally controlled systems are less exposed to malevolent activities than blockchains and can therefore direct their processing capacity at the task at hand rather than juggling correct execution of commands and operability.
When cryptocurrency trading is concerned, custodial exchanges pose a certain difference compared to how cryptocurrencies work on their own. When someone sends cryptocurrency to someone else, that transaction is written into the blockchain for a certain fee most of the time. Custodial exchanges also perform transactions in a way since traders swap their cryptocurrencies or fiat currencies among themselves, while trading, as the assets travel between the users’ balances. However, those balances are all part of one and the same wallet – the wallet of the exchange.
Thus, the trades are not written into the blockchain but are only registered on the exchanges’ servers. This allows custodial exchanges to have order books with trades spread across the price range of the trading pair and process the trades very fast compared to blockchain transactions. And the exchange makes money off the fees it takes from every trade performed on the exchange and for withdrawals of cryptocurrencies and fiat currencies from the exchange.
Problematic Issues With Custodial Exchanges
However, this creates a serious downside that users should be wary about. The wallet of the exchange is not the wallet of the user, and the exchange is the only entity that has the keys to it. This means that it can disallow the users to withdraw their funds for one reason or another. Sometimes, the exchange personnel simply vanished into thin air and stole their users’ funds. There have been a few cases, one of the most memorable is WEX.
There is also another risk that custodial exchanges pose for their users’ funds. Since their wallets store colossal amounts of liquidity, custodial exchanges often become the target of hackers. And there have been multiple instances of hackers siphoning off colossal amounts of Bitcoins and other coins from exchanges of this type. Some of the instances include Mt. Gox in 2014, Bitfinex in 2016 and Binance in 2019.
Therefore, users should pay close attention to security measures on custodial exchanges and the reputation of the exchange when they are looking for one to trade on.
What Are Non-Custodial Crypto Exchanges?
Non-custodial exchanges are completely different from custodial ones. They are basically smart contracts deployed on particular blockchains and have no physical infrastructure. Therefore, they are only as fast as the blockchain they work on.
Non-custodial exchanges do not hold any of the users’ funds, they only provide a smart-contract (protocols) that users can use to trade. The users connect their wallets to the smart contract and can start trading. And non-custodial exchanges have liquidity pools instead of order books. Liquidity pools represent a single trading pair with a certain amount of liquidity. Therefore, the amount of liquidity in the pools largely determines the trading volume that can be on a non-custodial exchange.
Liquidity pools provide another way for the users to make profit – liquidity provision. The liquidity in liquidity pools is provided by liquidity providers who are users who connect their cryptocurrency wallets to the smart contract of the exchange to delegate their coins to a particular liquidity pool on the exchange. For every trade performed in the pool, liquidity providers earn a certain fee, which is proportional to the share of the liquidity of every liquidity provider to the aggregated liquidity in the pool.
Intricacies Of Non-Custodial Exchanges
However, non-custodial exchanges require particular wallets compatible with the smart contract of the exchange and are significantly less straightforward. It takes some studying and learning to start using a non-custodial exchange to your full benefit.
Another downside of non-custodial exchanges is the speed of execution of transactions and the cost of transaction processing. Initially, non-custodial exchanges were being massively deployed on the Ethereum blockchain due to its extensive user base, Ethereum Virtual Machine and comprehensive smart contract standards. However, the one big limitation of this blockchain is its proof-of-work consensus algorithm and poor scalability. This blockchain can process between 13 and 15 transactions per second. With the rising popularity of non-custodial exchanges, the cost for transactions on Ethereum rose speedily, reaching over $100 at times, which created a serious problem for the users.
Alternative solutions started to appear in 2020 with the DeFi hype, Binance Smart Chain and Polkadot being the two most popular ones. Both offer high transaction throughput and low transaction cost, but Ethereum is still the most popular DeFi ecosystem. So, the problem is still there.
Still, the fact that you can have control over your coins at all times along with the multiple profit opportunities that non-custodial exchanges create has attracted very many people to exchanges of this type.
StealthEX is a non-custodial exchanger that never holds your funds. We offer you a wide range of assets that is regularly updated for you to buy and sell. And all you need to do is select the asset you want to buy, select the amount of the currency you want to buy with and specify your wallet address.
The views and opinions expressed here are solely those of the author. Every investment and trading move involves risk. You should conduct your own research when making a decision.
Updated on 15 March 2022.