Are Decentralized Exchanges The Future For Crypto?

Decentralized Exchanges

Cryptocurrencies continue to expand in their use cases and popularity around the world despite push back by some regulators and skepticism from traditional economists. Cryptocurrencies have created an environment free from the centralized control of government limitation and financial insiders’ agendas.

While these tokens have some very exciting traits there are still some factors holding them back from true freedom and decentralization. One of these factors is the centralized nature of most exchanges. Since transactions are at the core of these currencies, in order to stay true to Satoshi’s original vision exchanges must make the transition to a fully decentralized ecosystem. But, are decentralized exchanges better than centralized exchanges?

In order to examine the ways this shift from centralized exchanges (CEX) to decentralized exchanges (DEX) can be achieved, as well as some of the projects that are actively working towards this goal, first, we must understand how crypto exchanges currently function.

What Are Cryptocurrency Exchanges?

Crypto exchanges, like any other currency exchange, provide users with a means to change from one currency to another by working as an equitable intermediary. Exchanges also allow users to trade with each other as well as exchange crypto for fiat currencies like USD or GBP.

Generally speaking, there are two types of exchanges: currency-specific & currency-neutral. Currency-specific exchanges are built around a single platform, like BTC or ETH and only transactions between this token can be made. Currency-neutral exchanges offer trades between a number of different coins by acting as a trusted third party.

Different exchanges often have different functions, with some designed for more specific purposes, such as efficient crypto to fiat exchanges. Others are designed with regular traders in mind and provide lower commissions on transactions, although all exchanges charge some sort of fees for the services provided.

Prices for tokens are also determined by each exchange. The price of a coin is calculated by each exchange based on its volume of trades along with the supply and demand of users, meaning that the bigger the exchange, the more input for these calculations and a price that is more accurately applied in the market. This is one reason why there are a handful of large exchanges that dominate the trading landscape.

Users create an account on an exchange and transfer the funds they wish to trade with onto the platform; they are then free to trade for different coins. The exchange will put them into contact with other users that have the tokens they are looking for and a transaction can then take place using the exchange as the intermediary.

This all seems simple enough. However, these centralized exchanges have a number of their own issues.

Problems With Centralized Exchanges

Centralized exchanges do serve a purpose, and many do it quite well, however, they are not perfect. Beyond the philosophical act of straying from Satoshi’s trustless vision, there are very serious, real-world implications of operating an exchange organized in this way.

Honey Pots

These exchanges usually require users to deposit their tokens on the network itself; forfeiting control of their assets for a period in order to execute a trade. Some users even store their coins on an exchange, although this is never a good idea. However, just the fact that there are large pools of coins stored on the exchange for the time it takes to execute a trade makes them massive targets for hackers.

Throughout the short and rather turbulent history of cryptocurrencies, there have been a number of cyber-attacks that resulted in the loss of huge amounts of money. One of the more famous cases was the Mt. Gox attack.

On June 19, 2011, an attack on the Mt. Gox exchange, at the time the largest Bitcoin intermediary, allowed a hacker to fraudulently drop the nominal price of BTC to one cent. They then transferred the coins to themselves and the price reverted back to its previous trading value. It is estimated that around $460 million worth of BTC was stolen all because a hacker was able to exploit a weakness in the protocol that was accessible due to the centralization of hot wallets on the network.

Pay To Play

Another downside to centralized exchanges is the cost. Since these networks are based on a trusted third party facilitating all trades there are always some sort of fees associated with transactions. These fees can be more than one might expect.

There are often deposit fees, withdrawal fees and trading fees. Sometimes exchanges can get tricky in the distribution of the costs as well: claims of ‘no deposit fees’ will often be reflected in higher trading fees. ‘No trading fees’ can mean higher withdrawal fees. Then there can also be conversion fees when converting fiat to crypto and back again. While the numbers may look small—Bittrex takes a fixed cut of 0.25% of all trades while Binance functions similarly but with rates closer to 0.1%—when regularly trading these can add up.

Issues With Authority

Another major drawback to these exchanges and their centralized organization is that they fall under the authority of whatever country they operate out of. This is a real issue since there are a number of countries clamping down on cryptocurrencies. China and India, the two most populous countries on the planet, have banned cryptocurrency exchanges outright, while a number of other countries including Brazil and Russia have placed restrictions on them. Know Your Customer and Anti-Money Laundering regulations, as well as issues of government censorship, also have implications for CEX.

What Are Decentralized Exchanges?

Since the cornerstone of the values of cryptocurrencies is decentralization and a trustless means to conduct transactions, it seems that the development of decentralized exchanges is inevitable. While this may be the case, the vision is far from a reality. Currently, most exchanges that claim to be DEX are actually some form of hybrid, with certain functions being decentralized while other operations remain under a central authority.

Smart Contracts & Atomic Swaps

Most DEX utilize smart contracts to facilitate trading. Smart contracts are programs enacted between two or more parties that allow certain actions to take place only after specific requirements are met. Smart contracts are practically infinite in their uses when properly implemented.

Atomic swaps utilize smart contracts in order to provide secure trades between two parties with no intermediary. Normally two parties send their tokens to an exchange and then receive the traded tokens from the intermediary. Instead, these Atomic swaps take advantage of smart contracts to facilitate trades in one single, atomic action. Atomic swaps are a useful tool in the quest for decentralized exchanges and provide a means for peer-to-peer trading. However, since they are strictly peer-to-peer and cannot be broadcast to a network they alone cannot create a trustless exchange.

Real-World Examples

While most DEXs are some sort of hybrid, with both centralized and decentralized aspects, there are some projects that are definitely worth examining.

One of these exchanges utilizing decentralized technology is 0x. 0x uses ERC20 tokens and the Ethereum blockchain’s smart contracts to facilitate decentralized trades. Using their internal token (ZRX), 0x allows participants to essentially function as their own exchange. 0x utilizes a hybrid approach by using an off-chain, trusted third party for order matching while the trades themselves are executed on the blockchain utilizing smart contracts. The 0x team argues that while this is not decentralized in the strictest sense, it creates a system for trades that combines the best of both worlds.

Another decentralized exchange is Kyber. This project also takes advantage of Ethereum’s smart contracts to create a system without a centralized authority. Kyber has a central reserve for tokens (KNC) while also allowing users to create their own reserves and set their own rates which act as a pool for the exchange. This allows fast transaction times while maintaining a decentralized format.

Both of these projects provide an interesting glimpse into the future of decentralized exchanges. While many in the cryptosphere see decentralized exchanges as the future of crypto DEX still have their own set of issues.

Downsides Of Decentralized Exchanges

There are some issues with decentralized exchanges. The greatest problem facing the adoption of decentralized exchanges at this point is simply the functionality compared to centralized exchanges. Centralized exchanges have the advantage of already having fully functioning technology. Also as we have seen, most of these exchanges are only able to function as partially decentralized. There have been few examples of all four functions of an exchange—capital deposits, order matching, order books and asset exchange—being successfully decentralized.

Another issue with these decentralized exchanges is that, since they often utilize smart contracts to operate, the strength of these programs is of the utmost importance. Unfortunately, these exchanges are only as strong the smart contracts that they are built on, and these smart contracts are only as strong as the people who create them. As we have seen, there have been a number of instances where smart contracts have failed, and when functioning as an exchange, this type of failure can prove disastrous.

A Decentralized Future For Exchanges

It seems an obvious evolution in the crypto world towards a fully decentralized ecosystem. The advantages are both abstract and practical and there are few in the industry who don’t see the potential for these systems. While every day there are advances made toward removing third parties and creating a truly trustless environment, it seems we are still waiting for the first truly decentralized crypto exchange.

 


 

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References

0x. (NA). Powering Decentralized Exchange. Retrieved from: https://0x.org/

Kyber Network. (2018). Seamless Token Swaps, Anywhere. Retrieved from: https://kyber.network/

Leighton, B. (2019, March 15). What Is A Cryptocurrency Exchange And How Do They Work? Retrieved from: https://www.coininsider.com/cryptocurrency-exchanges/

McMillan, R. (2014, May 3). The Inside Story Of Mt. Gox, Bitcoin’s $460 Million Disaster. Retrieved from: https://www.wired.com/2014/03/bitcoin-exchange/

Nakamoto, S. (2009, January 9). Bitcoin: A Peer-To-Peer Electronic Cash System. Retrieved from: https://bitcoin.org/bitcoin.pdf

Olickel, H. (2016, June 21). Why Smart Contracts Fail? Undiscovered Bugs And What We Can Do About Them. Retrieved from: https://medium.com/@hrishiolickel/why-smart-contracts-fail-undiscovered-bugs-and-what-we-can-do-about-them-119aa2843007

Seth, S. (2019, June 25). Is Bitcoin Banned In China? Retrieved from: https://www.investopedia.com/news/bitcoin-banned-china/

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