With the collapse of multiple exchanges over the past few months, I think it’s important to breakdown what centralized exchanges actually are and how they work in the backend. If you really want to be a Moonboy, you must equip yourself with as much knowledge as possible to prevent asset loss and optimize your risk management strategies. So let’s dive in and get educated!
When you first get into crypto investing you are essentially transitioning from an old system into a new system. You need to find a service provider or custodian to sell you crypto in exchange for your fiat or cash. Currently, there are over 600 centralized crypto exchanges in the world today. So which ones should you use? Which ones can you trust, and which ones are safe? The short answer is nothing is 100% safe. This is about risk management and understanding how to give yourself the highest probability of not losing your funds. You should first research the top crypto exchanges by trading volume on trusted sites like Coinmarketcap or Coingecko. Once you have done that research, find out which ones have been around for a very long time—examples of exchanges that have been around a long time are exchanges such as Binance or Coinbase. Once you have decided which exchange is suitable for you, you need to sign up, go through a stringent KYC process, and link your bank account details to the exchange. Once that is complete, you are now ready to buy crypto.
Understanding the job is not finished once you have bought crypto is essential. Ideally, you want to set up a software or hardware wallet to self custody your assets and take them off the exchange. This is actually something we recommend that you do FIRST before setting up a centralized exchange or CEX account. We have detailed information on this step and understanding the risk involved in our MCV academy. Once you have bought the crypto, the next step to protect yourself is to store it offline in a software or hardware wallet, as previously stated. Many do not know, but cryptocurrency is transferable. That is one of the significant use cases of the technology. You can move your assets into your own personal wallet that only you have access to. The reciprocate example would be your money at a bank that you can go to an atm and withdraw physical cash out of and put into your wallet or safe. In this case, the bank is the CEX, and the wallet is your software wallet, while the safe would be your hardware wallet. This is the best way to describe the relationship between the three, so you can best understand. You can refer to our latest form of digital ownership content to better understand the importance of self-custody.
The risk of centralized exchanges is very real. Users must realize there is no transparency on what is happening in these exchanges' backends. Not all exchanges back your liquidity 1:1. Some leverage your funds to others in return for yield similar to a bank. The only difference is that banks can be saved by the federal reserve if there is a threat of insolvency, essentially becoming too big to fail. In the case of crypto exchanges, there is no fail-safe in case something were to go wrong, and many exchanges are not public, fully regulated, or insured. It is essential to understand the risk of keeping your funds on exchanges like Robinhood or Sofi where you can’t transfer or store them yourself. And keeping your funds on more prominent crypto exchanges that allow you to transfer them is even more dangerous, especially when they aren’t fully regulated. Centralized exchanges are only for swapping assets, not for storing your assets long term. When the exchange goes out of business, all assets left on that exchange will become the founders of that exchange’s exit liquidity. Do not become exit liquidity for someone else. Invest in yourself, and take time to educate yourselves on centralized exchanges and the difference between them and a decentralized exchange. Education is the best weapon you can use for optimal risk management.
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