This is the ultimate guide for cryptocurrency Decentralized Exchanges.
Centralization, or lack thereof, is a major talking point in cryptocurrency. While some people are attracted to the technology purely for the lucrative gains to be won investing or speculating on upcoming projects, cryptocurrency means something more to many other enthusiasts.
Decentralized blockchain technology heralds a changing of the status quo. A leveling of the playing field in which financial power is placed in the hands of the individual instead of centralized banks and corporate entities (can you tell which side I’m on yet?)
Yes, there will always be whales and hedge funds trying to game the system. Bitcoin is controlled mostly by a small number of powerful mining pools, for example, a far sight from Satoshi’s vision. However, it did get the ball rolling, and since then more projects have been striving for true decentralization.
Before we get too far into it, let’s clear one thing up;
What’s a centralized exchange exactly?
Good question. A centralized cryptocurrency exchange is one in which a third party controls everything. Custody of the currency, the order books, the whole thing. If you buy cryptocurrency on an exchange like Coinbase, Bitfinex, Binance, you know what I mean – these are all centralized exchanges.
You can buy and trade currencies on them, but any currency stored on the exchange is not in your possession, so it’s always a good idea to withdraw your currency to a private wallet where you alone control the private keys. Remember the wise words of Andreas Antonopoulos – not your keys, not your Bitcoin!
Why is decentralization important?
Let’s take a look at a current example of centralization failing miserably.
For months, Bitgrail was the number one place to buy XRB tokens from Raiblocks, now rebranded as NANO. Many people had difficulty withdrawing their currency, with only limited windows available to do so. This was a massive red flag, but for all the people who recognised that it seems there were just as many who didn’t, and when Bitgrail claimed to have lost hundreds of millions of dollars’ worth of user tokens in a “hack”, a lot of people lost a lot of money, possibly with no legal recourse.
One man, Francesco Firano, is in charge of Bitgrail. It’s an unregulated exchange with many international users from around the world, and the likelihood of those people successfully recovering their money is more or less zero.
What can we do to avoid scams and hacked exchanges like this? Reduce the human error.
Decentralized exchange projects
Picture this as an alternative: An exchange not controlled by any one group or entity, with no single point of attack for hackers to steal information from. We already use nigh-unhackable blockchain technology as the protocol for cryptocurrencies – why not use it as the protocol for the exchanges themselves? Here are some promising projects working on exactly that.
This is a project in development by Bitfinex, a well-established centralized exchange. Though not yet decentralized, the project aims to be “trustless, decentralized and scalable”, trustless meaning that users won’t need to place trust in a third party to secure transactions and trades.
Ethfinex plans to facilitate relatively liquid Ethereum trading – due to the nature of blockchain technology, decentralized exchange models are still quite illiquid, meaning that the assets are not easily and swiftly transferrable compared to other systems. Slower transaction times allowing for multi-node verification of each transaction are the trade-off for decentralization and security, but some projects are aiming to have the best of both worlds.
Still, in the early days of alpha testing, this project is a “simple on-chain market for all token assets in the Maker registry”. The list currently includes ETH and a handful of others, and is likely to expand.
It’s an interesting system – while you have an on-screen balance, you can’t use it to trade directly. It needs to go through an Ethereum smart contract first, meaning that the process will be a slow one, not ideal for day trading, but fine for simple trading requirements, and of course, safe and trustless once it’s fully up and running.
Described in the whitepaper as an “open protocol for decentralized exchange on the Ethereum blockchain”, 0x aims to increase liquidity and find a middle-ground between vulnerable centralized exchanges and slow, cumbersome blockchain exchanges. The image below from the Ox blog highlights the differences between 0x and other systems.
As you can see, it’s a similar concept to that of the Lightning Network. Activity on the blockchain is minimized by handling all pre-transaction processes on an off-chain system. This only involves the blockchain to execute the Ethereum smart contract.
It’s important to note that 0x doesn’t seek to be an actual exchange – it’s simply a protocol, a program that facilitates trading. The main takeaway from this project is that it won’t be lightning fast or incredibly slow, but somewhere in between. It doesn’t require third-party trust and it won’t clog up the Ethereum blockchain. Now in development, this could well be the exchange solution we’re all looking for.
Other projects take a different approach, like Ether Delta, a decentralized exchange with a centralized order book. Obviously, the more approaches being tested, the more data gathered for the seemingly inevitable success of the technology.
Tax and regulation
While centralized exchanges are liable to government regulation, their decentralized counterparts are not. Though regulation comes with an increased sense of security for some, with regulation comes tax. In the US, cryptocurrencies are technically as capital assets. This means they can be subject to capital gains tax of 15% – 20%.
Ideally, decentralized exchanges won’t require regulation to ensure security from loss of funds, as the technology itself will provide this. The blockchain tech also makes it difficult to regulate the exchange even if the government wants to. Why? There’s no one person, entity, or authority in charge of the exchange. Such exchanges have heightened anonymity and will be very difficult to tax or regulate. Not just user compliance, but legislating for such regulations in the first place.
It’s all very interesting – is it possible?
OK, we don’t have a truly 100% decentralized exchange up and running just yet. However, the above projects are only a handful of those working on a solution. It’s certainly possible in theory. If past developments in the space are anything to go by, that means that we could be seeing functional, unregulated, and secure decentralized exchanges sooner rather than later.
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