Thread by @johnnie_jacks

“How can I trade coins on your exchange you don’t hold anymore after the hack?”

Just one of SO MANY comments I’ve seen today where people truly don’t understand how centralized exchanges (CEX) such as Binance, Kucoin and others work.

Let’s look into it.

A thread.

1/ when you send funds to a CEX you are sending the token from your wallet to theirs.

The exchange then holds them on your behalf (in escrow) in their own wallets.

They credit your “account” on the exchange with your coins

2/ this is why people say “not your keys, not your coins”.

The exchange now owns your coins.

They can choose to do anything they want with them - including stopping you from withdrawing them, disappearing with them or allowing hackers to take them.

3/ on the flip side, they may compensate you if you make a mistake for some, may be better placed to secure your funds than you are.

But don’t be mistaken.

You’re making a choice to trust them.

This is antithetical to the basic rule of crypto “don’t trust, verify”

4/ They now total control over your tokens.

While most of us don’t like it in theory, in practice we like the ease of use, access to liquidity and relatively low fees associated with trading on them.

5/ This is where the principal of keeping your counter-party risk as low as possible comes in.

Intelligent use of leverage and of personal cold storage will help protect you from the risk of using a CEX

Refer to @KoroushAK posts on the subject for more info.

6/ The fact that this is against the basic tenets of crypto is why decentralized exchanges (DEX) are gaining some traction.

They allow users to transact directly with each other, never sending funds to a third party. This removes the “trust” element.

7/ Although they’ve been around for years, the first DEX with real traction is Uniswap but it has its own issues.

Some of biggest right now are: often astronomical transaction fees, lack of order book, lack of good charting tools etc.

8/ these are being addressed but the fact is that CEX are still the easiest to use, cheapest and most established platforms to trade crypto on - for now.

This brings us back to the first question - how do trades actually work?

9/ Your account on the CEX doesn’t transact anything on the blockchain at all.

They have an internal ledger that shows how much of each asset each user owns and has traded.

When you make a trade this is simply updated on their internal ledger.

Let’s look at a simple example.

10/ I sent 1 BTC to the exchange. You send 10,700 USDT to the same exchange - let’s call it “Trinance”.

Your Trinance account shows your USDT, mine shows my BTC.

In reality both of our coins are just sitting in Trinance’s own wallet.

11/ we do a trade.

I sell you my 1 BTC for 10,700 USDT.

Trinance takes its fees (but for simplicity let’s ignore that for now) and your account now shows 1 BTC, mine shows 10,700 USDT

However on the blockchain, nothing at all has happened.

12/ the tokens have stayed in Trinance’s wallet the whole time, the only thing that’s changed is their internal ledger that shows which user has which coins.

When you go to withdraw your 1 BTC then only at that point does it actually move out of their wallet and into yours.

13/ this is why it’s technically possible for CEX to operate as giant Ponzi schemes.

As long as nobody withdraws their coins, or enough people don’t do it at the same time, it’s possible for the exchange to keep processing “trades” without holding the coins at all.

14/ This has happened in the past, and accusations of exchanges using user tokens for trading or arbitrate are rife.

These are hard to prove if they do it intelligently.

Many legal investigations are still ongoing.

15/ i hope you now better understand how a CEX works.

In the current climate using them is really inescapable.

We should be aware we’re trusting sometimes very suspect “companies” with total power over our tokens and as such we should try to control our risk as far as we can.