When Satoshi Nakamoto released the Bitcoin whitepaper, it was obvious that decentralization would underpin the digital currency’s success and application in the real world. However, from the inception of the cryptocurrency industry, the exchanges on which users could buy and sell digital currencies were mostly centralized, perpetuating the issues of big banks and financial institutions.
Recently, a new class of cryptocurrency exchanges has emerged. These decentralized exchanges provide users a platform to buy and sell cryptocurrencies, but are not operated by one centralized entity and instead function as a decentralized platform for trading. Although these initiatives provide a solution to the issue of centralization, they have their own problems which prevent them from achieving mainstream adoption.
Security and Anonymity
While there are a slew of cryptocurrency exchange options available to token holders, the majority of these services share a common problem: centralization. Well-known exchanges such as Coinbase, Gemini, and others are owned and operated primarily by a single company, and operate much the same as a securities exchange: taking orders, matching buyers and sellers, conducting transactions, and offering a place to store cryptocurrency (also known as a “wallet”).
As former users of Mt. Gox, Coincheck, Bithumb, and others are too well aware, handing funds over to any centralized exchange means giving up control and security of cryptocurrency. Conversely, a platform where cryptocurrency trading is decentralized renders hacking and theft almost impossible as they do not offer one central point of failure. Moreover, users are in complete control of their funds, as they never store their coins on the exchange itself, and use it solely for conducting trades.
Exchanges that operate in this way preserve the privacy and anonymity of their users by never requiring personal data or information. While centralized exchanges require the submission of name, address, government-issued ID, and other pieces of personal information, their decentralized counterparts allow tokens to be freely traded, eliminating any risk of government interference or censorship.
It must also be noted that in order for an exchange to be truly decentralized, it must operate its entire business in a decentralized way. This applies to everything from web hosting to data storage and more. Failure to apply this fundamental approach was the cause of the hacking of EtherDelta, which a decentralized cryptocurrency trading platform that hosted its domain on centralized servers, so creating a critical security vulnerability.
For all the benefits of decentralized exchanges, they have yet to provide an easy to use experience for new customers. A number of different types of decentralized exchanges currently exist, but all have issues which need addressing.
Pegged Asset Exchange
Exchanges such as Waves offer a decentralized platform on which to trade tokens which are pegged to underlying assets. While exchanges utilizing pegged assets claim their tokens are pegged directly, trading in such tokens leaves more room for price manipulation. Additionally, this creates an extra step for users who must purchase Bitcoin or another cryptocurrency, convert that cryptocurrency into a pegged asset, trade that pegged asset for another pegged asset, and convert the newly received token back into the crypto or fiat currency of their choosing.
While peer-to-peer cryptocurrency exchanges may seem ideal in many ways, they fail to provide an easy solution for trading. Usually, a peer-to-peer exchange works by putting digital currency in an escrow account while fiat or cryptocurrency is transferred off-exchange. Then, once the transfer is confirmed, the funds from the escrow account are released and the trade is completed. This is a multi-step process, part of which must be completed off the exchange entirely. Projects that utilize peer-to-peer functionality that automate this process, such as 0x, conduct this order matching for users in an automated fashion off of the blockchain, which makes the process much easier and quicker for the end user. The only downside to this off-chain, automated order matching is that it comes with an added fee.
Regardless of the type of decentralized exchange, almost all of these options have one thing in common: they are unable to provide an easy-to-use and quick exchange from fiat to cryptocurrency. Users of Coinbase and other major centralized exchanges find it simple to go from a credit card, bank account, etc. to cryptocurrency in a matter of seconds, but this is still not possible on decentralized trading platforms.
Liquidity is the lifeblood of any trading exchange; without it, an exchange is rendered effectively useless. Low liquidity results in traders being unable to obtain the best prices on the market, and orders taking a long time to fill. Decentralized options for cryptocurrency trading have yet to crack the top 50 in trading volume across all exchanges, as user adoption has been slow to ramp up on these platforms. Generating market liquidity is seemingly a circular process: users are hesitant to try a new exchange if there is no liquidity, but without new users on board it is difficult to build a base of customers that can provide such liquidity in the first place.
However, some decentralized exchanges, such as Bancor, are attempting to reinvent liquidity and eliminate this problem altogether. By using smart contracts anyone can create a token or basket of tokens, known as “Smart Tokens”, which are forms of currency that can hold other currency. These Smart Tokens are bought and sold not between users, but between smart contracts which set market prices. In this way, Bancor claims to guarantee liquidity on its exchange, a statement that if true, could change the entire exchange industry.
New decentralized exchanges now pop up with increasing regularity. All provide a solution to the problem of centralization and apply their own take on how to correct the other issues that exist with current decentralized platforms. However, until issues surrounding usability and liquidity are resolved, it will be unlikely that any decentralized cryptocurrency exchange will achieve mass adoption.
As long as centralized exchanges provide easy-to-use and faster trading, the majority of cryptocurrency users will gravitate towards them. There is still a great deal of room for improvement, but it remains to be seen if any decentralized exchange will provide all the necessary tools and functionality to serve the entire industry.