Centralized crypto exchanges are online platforms that allow users to buy, sell, and trade cryptocurrencies. These exchanges are centralized in that they are operated by a single organization which controls the platform and takes custody of users’ funds.
There are several risks associated with using a centralized crypto exchange:
- Security risks: Centralized exchanges hold a large amount of user funds and are therefore attractive targets for hackers. If the exchange’s security is compromised, users’ funds may be stolen or lost.
- Custodial risk: When you use a centralized exchange, you more-often-than not entrust your funds to the exchange. If the exchange fails or goes out of business, you may lose access to your funds.
- Regulation: Centralized exchanges are subject to the laws and regulations of the countries in which they operate. CEXs require customers to KYC and are required to comply with AML standards, however the regulatory frameworks and the amount of user protection they offer differ significantly from country-to-country so knowing where the CEX is located is clearly important. In any event, regulations currently do not offer the same level of user protection or transparency as in TradeFi, as was seen with the collapse of FTX.
- Lack of control: When you use a centralized exchange, you are relinquishing control of your funds to the exchange; we discussed this in our blog “Becoming Your Own Bank”. Not being in control of your digital assets can be problematic for a whole variety of reasons, but most particularly in the event of a liquidity crisis; this is where cover protection against withdrawal halts, currently available for Binance Exchange and OKX Exchange in the Neptune Mutual marketplace, is an excellent means of mitigating this type or risk.
- Counterparty risk: When you use a centralized exchange, you are relying on the exchange to facilitate your trades. If the exchange fails to execute a trade or if there is a dispute, you may be at risk of losing your funds.
Overall, it is important to carefully consider the risks associated with using a centralized crypto exchange and to choose a reputable and secure platform.
Audits, Proof-of-Reserves and CEX Transparency
The idea behind audits and proof-of-reserves is to provide transparency about whether they hold sufficient reserves of assets to match user deposits. This is important because in the event that users wish to withdraw their assets then the CEX needs to be able to have sufficient reserves to meet this demand. Financial institutions, with TradeFi, CeFi or DeFi depend to some degree on confidence and trust. Transparency is one way of creating this trust, particularly in the blockchain industry where the regulatory environment that is designed to protect users is significantly less onerous than in TradeFi.
CEXs that have committed to publishing proof-of-reserves include: Binance, Bitfinex, Bitget, Bybit, Crypto.com, Deribit, Huobi, KuCoin, OKX and Poloniex.
But to-date, Proof-of-Reserves have had only limited success in providing the community with any real level of confidence. Many questions remain unanswered about the validity and independence of the proof-of-reserves and financial commentaries/audits that are being provided by exchanges. Michael Burry, who became famous for recognising the danger of the subprime mortgage crisis and from acting on this insight to make money from it, “The Big Short”, Tweeted:
How to Mitigate Risk of CEX
There are several ways to reduce and mitigate the risks of using a centralized crypto exchange:
- Mitigate risk by purchasing cover protection from a DeFi Insurance protocol. Neptune Mutual’s cover marketplace offers cover policies that protect CeFi users against security and custody risks for CeFi projects, including Binance Exchange and the OKX Exchange.
- Use a reputable exchange: It is important to do your research and choose a reputable and trustworthy exchange. Look for an exchange that has a good track record of security and has implemented strong security measures to protect user funds.
- Do some research into cyber hygiene and how to stay secure. You can start with our blog, “10 Tips on Securing Your Online Account”.
- Enable two-factor authentication: Many exchanges offer two-factor authentication (2FA), which requires an additional layer of security beyond just a password. Enabling 2FA can help protect your account from unauthorized access.
- Use a hardware wallet: If you want to store your cryptocurrencies in a more secure way, you can use a hardware wallet. A hardware wallet is a physical device that stores your private keys and allows you to access your cryptocurrencies offline. This can help protect your funds from hacking and other security threats.
- Spread your risk: Instead of keeping all of your funds on a single exchange, you can spread your risk by using multiple exchanges or by storing some of your funds in a hardware wallet.
- Enable withdrawal limits: Many exchanges allow you to set withdrawal limits, which can help prevent unauthorized withdrawals from your account.
- Use a decentralized exchange: If you are concerned about the risks of using a centralized exchange, you may want to consider using a decentralized exchange (DEX). DEXs are operated on a peer-to-peer basis and do not hold users’ funds, which can reduce the risk of loss. However, it is important to note that DEXs may have other risks, such as liquidity issues and the possibility of smart contract bugs.
Therefore, it is important to be aware of the risks associated with using a centralized crypto exchange and to take steps to protect your funds.
Final Thoughts
Overall, understanding the cybersecurity risks of cryptocurrency is essential to keeping your digital funds safe. By taking the right precautions to reduce risk and by purchasing cover to protect your digital assets in the event of an incident, you can put in place an effective way to manage the risks discussed in the article. However, all that said, it is essential to remember that the risks of using cryptocurrency should not be underestimated.
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