Liquidity risks associated with cryptocurrency exchange services

Centralized exchanges (CEXs) are run by a central authority that has full access to customer assets. CEXs fulfil trades much like a fiat exchange, where an order book ensures that there is enough liquidity. However, users on centralized exchanges are prone to liquidity crunches and security breaches. 

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Risks

• "Insecurity, risk of fund loss and thefts due to their centralized functioning. They are legally accountable and a custodian of users’ funds. 73% of centralized exchanges take custody of user funds, while 23% let users control keys⁴. They represent honeypots for hackers as they are responsible for billions of trades per day and store most of them on their servers.
• A lack of liquidity: large orders struggle to be matched. Even at an all-time-high, volumes remain low (compared to traditional markets).
• A fragmented (not to say decentralized) market: divides the global liquidity into a few main marketplaces. No clear market leader in terms of volume, which increases the liquidity problem.
• A high level of risks for users due to potential performance issues, market manipulation, hardware failures, latency problems, and many other inherent problems when it comes to dealing with large volumes…
• A lack of trust and transparency: actual costs and processes of trading are opaque and involve high trading costs, often higher than announced fees and higher delays due to peaks of demand badly managed. Plus, they can front-run orders, which is illegal.
• A lack of educated users: markets are flooded by pure speculators unaware of safe ways to deal with cryptocurrencies."

Source: Consensys, last revised 1 Jan 2018

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"Disadvantages of Centralized Cryptocurrency Exchanges

1. Hacking risk

Centralized exchanges are operated by companies that are responsible for the holdings of their customers. Large exchanges usually hold billions of dollars worth of bitcoin, making them a target for hackers and theft.

An example of such an incident is Mt.Gox, which was once the world’s largest cryptocurrency exchange company before it reported the theft of 850,000 bitcoins, leading to its collapse.

2. Transaction fees

Unlike peer-to-peer transactions, centralized exchanges often charge high transaction fees for their services and convenience, which can be especially high when trading in large amounts.

3. Custody of digital assets and risk of fraud

Lastly and most importantly, most CEXs will hold your digital asset as a custodian in their own digital wallet rather than allow you to store your private keys on your own digital wallet. While more convenient when you want to trade, there are drawbacks, namely the risk of the centralized cryptocurrency exchange failing and fraud.

Recent examples include the failure of the 50 USD billion algorithmic stablecoin TerraUSD and sister token Luna, the bankruptcies of hedge fund Three Arrows Capital, lender Celsius Network, broker Voyager Digital and the sudden collapse of FTX and Alameda Research."

Source: CFI, last revised 14 Nov 2022