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As we begin to see renewed interest in cryptocurrencies — with prices approaching all-time highs and prominent figures and institutions discussing the industry — building a strong crypto exchange is essential.
Cryptocurrency traders’ standards for exchanges are higher than ever. They are looking for a seamless user experience, architecture that supports high throughput and low latency, and top-notch security. The latter is especially important as the industry is still recovering from the collapse of FTX and the cascading effect it had on other companies in the space.
While centralized exchanges excel at building beautiful user interfaces and intuitive user experiences, they operate quickly by holding user funds on their behalf. As the industry has seen many times throughout the history of crypto, funds that are not controlled by the users themselves can be mismanaged by fraudulent entities. Additionally, crypto exchanges have the authority to restrict access to accounts, such as freezing funds or halting withdrawals. As the common crypto saying goes: Not your keys, not your coins.
On the other hand, decentralized exchanges give users complete control over their funds through self-custody. They leverage blockchain technology and smart contracts to execute trades and settlements without trust. However, this architecture can be unstable and complex for users. It comes with trade-offs in throughput and latency, lack of advanced trading features (such as advanced order types and conditions), and can also charge significant gas fees to settle on the blockchain.
A new generation of cryptocurrency entrepreneurs are thinking differently about exchange architecture. They are looking to combine aspects of centralized and decentralized exchanges while building on the best of both worlds. Enter the hybrid cryptocurrency exchange.
Better Trading Engine for Better Cryptocurrency Traders
Cryptocurrency exchanges of the last cycle, including Coinbase and Binance, have built their businesses by copying the user interface of brokerage platforms and mimicking the mechanics of brokerage platforms and the user interface of fintech apps. They have focused on user-friendly interfaces, robust mobile apps, competitive fees, and a wide range of currencies and tokens.
Centralized trading infrastructure provides high throughput and low latency, which is what the world demands for cryptocurrency trading. The depth of trading, high throughput, and low latency allow for better liquidity, as market makers can re-price faster. It also allows for more efficient use of margin, as the exchange’s centralized risk engine allows it to offer higher leverage. Centralization enables advanced trading features and logic, such as advanced order types and conditions.
Aside from performance, this allows exchanges to have more control over compliance. CEX exchanges control what customers can access on their platform and can manage those users’ access by implementing robust blockchain analytics, anti-financial crime software, and compliance. In the wake of FTX, regulators and law enforcement agencies have been cracking down on the industry, handing out massive fees and even jail time to companies and entrepreneurs found to be ignoring regulations.
So, in short, this is why the hybrid exchange model inherits the bright side of centralization. The trading architecture is largely kept centralized. The user experience is also inherited from CEXs because DEXs simply lack features, such as simple account creation, which eliminates the need for users to already have a wallet before interacting with the exchange. DEXs are also limited in entry and exit ramps, fee stripping, and advanced trading analytics. Especially as another wave of crypto traders enter the space during what appears to be the beginning of a bull run, a robust feature set on top of a polished user experience is crucial.
It all sounds like a flawless triumph for centralization so far. The question is, what do hybrid exchanges inherit from decentralized exchanges? The answer is simple: the fundamental feature that enables trust in cryptocurrency trading. Centralization has a dark side.
Give users keys
Hybrid exchanges still draw on DEX concepts by leveraging blockchain technology to secure funds. Users take care of their own custody of their funds, and trades are settled on the blockchain at different intervals. Another crucial feature is the validation of the trading logic on the chain, which will prevent operator fraud. Thus, trust can be proven, and transparency is immutable.
Operator fraud is one of the most significant risks in the crypto space. CEX control over funds is useful for compliance reasons; however, it also gives the power to restrict access to accounts, such as freezing funds or halting withdrawals. The collapse of FTX certainly heightened concerns about operator access to user funds. However, FTX was not the first or only exchange to mishandle user funds and question the CEX model. One of the first ever cryptocurrency exchanges, MtGox, completely shut down and declared bankruptcy in early 2014 due to an undetected theft that drained the exchange of over 850,000 Bitcoin (BTC) over the course of several years. In 2018, Canadian exchange QuadrigaCX disappeared and was later revealed to be a Ponzi scheme, causing the loss of approximately $190 million in user funds.
These ongoing cases highlight the importance of self-custody and trustless on-chain settlement, where users hold their own keys to their coins rather than trusting a completely opaque central entity to hold their keys.
Scaling up technology to reduce costs
In the derivatives market, traders often transact in large volumes, which can result in significant fees accruing. No trade is without fees. CEX and DEX exchanges charge trading fees, but DEX users incur an additional cost to settle all of their trades on the blockchain. These fees fluctuate based on the total usage of the blockchain in any given time period. Earlier this year, in March, Ethereum transactions were closed Costs Bitcoin’s value has surged to its highest level in nearly two years due to increased speculation in meme tokens.
The hybrid exchange approach simplifies the fee structure because trading is centralized and relies on layer 2 technology to enhance scalability while keeping transaction fees low. Aggregation is a scalability solution that processes transactions on a separate network before batching transaction data into batches for submission and settlement on the main chain.
Now is the time to switch to hybrid.
Combining features from a centralized and decentralized exchange architecture is an obvious choice in a market that is becoming more mature and competitive.
The speed, ease of use, and design of CEX help users of all levels of technical knowledge to trade cryptocurrencies with ease. The security provided by the implementation of DEX aspects will create an ecosystem of trust and reliability that gives users peace of mind.
The hybrid crypto exchange is expected to be the winning business model in the next bull run, highlighting that it’s not always about reinventing the wheel as much as it is about creatively putting the pieces together. It’s not a one-size-fits-all industry; it won’t have a one-size-fits-all solution.