What are Centralized Exchanges?
An exchange is a marketplace where assets, such as stocks or cryptocurrencies, are traded. Two well known centralized exchanges are the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE).
But what does “centralized” really mean?
It means that orders of assets are routed to the NYSE, for example, and matched with a corresponding order of the same price. This means that all orders are taking place in one specific “location”, as they are all routed through the NYSE.
Let’s say you would like to purchase some Bitcoin with US dollars. To do so, you need to transfer your money to a centralized exchange (e.g. Coinbase). After this, your US dollars would be converted by the exchange into Bitcoin at the current exchange rate.
If you have bought cryptocurrencies in the US (e.g. Bitcoin, Ethereum, Litecoin, Ripple), then you have used a centralized service or exchange, like one of the following:
What is Wrong With Centralized Exchanges?
Many many things, the primary one being security. We have all heard of Bitcoins getting stolen. It turns out that centralized exchanges also have many other issues, ranging from outages to high fees and risks of insider trading or front running.
Enter Decentralized Exchanges
A decentralized exchange is an exchange market that does not rely on a third party service to hold the customer’s funds. Instead, trades occur directly between users (peer to peer) through an automated process.
This system can be achieved by creating proxy tokens or through a decentralized multi-signature escrow system.
What Makes Decentralized Exchanges so Great?
Decentralized exchanges aim to solve close to all problems that plague centralized exchanges.
Here is a summary, followed by a breakdown of different drawbacks of centralized exchanges, and how decentralized exchanges solve them.
1. Data Storage Security
The biggest vulnerability of centralized exchanges is that they have online databases that store the public and private keys of their users. This makes them a fantastic target for hacking. This is a short list among countless companies whose cloud databases have been breached: Deloitte, Uber, Dropbox, Equifax, LinkedIn, Docusign, OneLogin, BlueCross Blue Shield, Verizon, and the SEC (!).
If these large organizations with sophisticated security teams were not able to store extremely confidential client data ranging from medical records to credit card information, it is safe to assume that at least a few of the centralized cryptocurrency exchanges will get hacked. Already, some of the biggest exchanges, Mt Gox, Bitfinex and Shapeshift have been hacked.
0x, a decentralized exchange protocol, explains how this problem is solved on its whitepaper:
Decentralized exchange will eliminate these risks by allowing users to transact trustlessly — without a middleman — and by placing the burden of security onto individual users rather than onto a single custodian.
Decentralized exchanges, by integrating with hardware wallets like Trezor and Ledger, allow users to safely store their coins on cold storage and trade tokens at the same time. This eliminates the possibility of large scale hacks, because there is no centralized cloud database that holds users’ private keys.
While users can be vulnerable to phishing attacks, fake websites that try to get users to reveal their pin codes or private keys to a hacker, my post on token security mentions how it is an easy problem to make an individual user secure against these kinds of attacks.
2. Server Downtime Issues
Since October 2017, almost every time Bitcoin or Ethereum prices fluctuated, most centralized exchanges had large scale outages.
Only in November and December alone, Coinbase had 30 incidents that relate to downtime, delays or maintenance. Almost every time Bitcoin dropped in price, it wasn’t possible for most users to sell Bitcoin until the volatility stopped.
Introducing the crypto world’s new blue screens of death.
Well designed decentralized exchanges will have the advantage of working like Napster or Bittorrent: every time more people log in to transact, the overall computational power of the system increases as more nodes are added.
3. Identity Breach Risks
Because many governments recently started to heavily regulate centralized exchanges for tax and oversight reasons, most of them started to ask for:
- Social Security Number
- Copy of Passport
- Copy of ID or Driver’s License
- Copy of Utility Bill
from their users before the user can trade above a few thousand dollars. We established that some exchanges will get hacked, and when they do, this information will be vulnerable as well.
Decentralized exchanges by design do not require authentication. The only requisite to trading is owning a hardware wallet or a web wallet. In other words, anyone can trade without logging in or creating a profile. No profile means no social security number or ID photo that can be stolen.
4. Laborious Verification Processes
Due to the large number of documents these centralized exchanges have to review manually, verification takes days and sometimes weeks. Furthermore, most exchanges impose deposit and withdrawal fees, which takes additional verification steps to overcome.
Given lack of a requisite for authentication and no deposit/withdrawal limits, decentralized exchanges do not have this problem.
5. High Fees
Most exchanges have extremely high fees. Coinbase’s fees are 1.49% by bank account or 3.99% by credit card in the US.
Most other exchanges have 0.25% in fees (Bittrex, Poloniex, GDAX).
Many decentralized exchanges like Waves are moving to a very small fixed fee system, where a $100,000 order will cost cents, compared to $1,490 on Coinbase and $250 on other centralized exchanges.
6. Price Manipulation/Insider Trading
Centralized exchanges are widely accused of doing front running and/or insider trading.
Front running is the unethical practice of an exchange trading a token in his personal account based on advanced knowledge of pending orders on the exchange, allowing him to profit from the knowledge. Exchanges are widely rumored to be doing this practice on Reddit, Steemit and other forums, but no one can prove it due to the opacity of the order books.
By design, decentralized exchanges avoid these issues, because the order book will be built on a public blockchain. When an order is submitted, a transaction (tx) is composed and sent to the network. This way, any party that checks the public blockchain will be notified simultaneously of the transaction.
Insider trading is having the advance knowledge of a new coin that will be listed on an exchange and amassing large amounts of it personally, anticipating a rise in its price upon its listing on the exchange. Coinbase employees were accused of insider trading and Coinbase launched an internal investigation.
Decentralized exchanges try to avoid this by various methods:
- Listing every ERC-20 token as they come out(e.g. Ether Delta)
- Having a public and transparent framework for picking what token to list, e.g. by market cap.
- Decentralized decision making, where token holders democratically decide which token will be listed.
There are dozens of decentralized exchanges, most of which are raising or have just raised ICOs. I expect many more to be founded in the next year, as the recent surge in crypto activity has exposed all of the shortcomings of centralized exchanges.
Below is a short list of the ones that look interesting to me. Many of them are fairly new and have many challenges to overcome, such as ease of use and liquidity, but I believe some will get there.
It won’t be long until some large players emerge from this vertical and challenge the titans of the centralized exchange world.
Big thanks to my dear friends Josh Eisner and Alexander Atallah for their edits on this blog post.