The emergence of cryptocurrency exchange platforms and websites where you can buy, sell, or exchange cryptocurrencies has absolutely everything to do with the recent phenomenon of initial coin offerings (ICOs). Through ICOs, companies and organizations are introducing their crypto-assets, also known as tokens, to the public and in the process are creating a new form of tradable digital asset, only made possible by Blockchain technology.
By conducting a fundraising event based on token sales, startups are able to further finance the development of their projects without relying on traditional venture capital. In fact, funds raised through ICOs have reached nearly four times the amount of money Bitcoin companies have raised in venture capital dollars just this year. According to PitchBook, ICO investments rose from $26 mln in 2014 to almost $1.3 bln in 2017, while traditional Blockchain companies saw only $358 mln in VC money over the same period of time.
More tokens, more problems for centralized exchanges
As more and more projects raise funds through the launches of platform tokens (ICOs), the number of tokens in the market is increasing, and investors in Blockchain companies and contributors to the various projects are acquiring a variety of tokens as part of their investment strategies. Unfortunately, limited options to liquidate all of these tokens in the market makes convertibility of one token to another a real challenge for both investors and operators alike.
One of the reasons behind this comes from the fact that most of the popular centralized exchanges require reserves of the tokens that they are trading. If a person wants to buy or sell a token that isn’t common, that person would have a hard time doing so because a token of this type is usually not supported by major centralized exchanges.
Finally, most existing centralized exchanges tend to require users to wait for several minutes before a trade can be confirmed, or before they are allowed to withdraw their proceeds from an exchange. As a result, the selling price many centralized exchange users see when they initiate a transaction might not necessarily be the price they see when a transaction is complete.
The security conundrum of centralization
While the daily trade volumes between notable cryptocurrencies, such as Bitcoin and Ether, may very well be in the tens of millions – the daily trades between all of the other crypto-assets entering the market, most of which are less than two years old, are also approaching these large trade volumes. The problem is, despite the decentralized and trustless nature of cryptocurrencies, the majority of this trading takes place on centralized exchanges, which are subject to fraud and hacking.
It seems as though there are monthly reports in the media about hacking attempts on major cryptocurrency exchanges. Looking deeper into the cause, one feature that many of these attacks have in common is that they are directed at centralized exchanges, which keep all of their user’s information including their private keys to access their Blockchain currency stored in a data ‘silo.’ This means that a hacker would only have to get into the system once to access every user’s information.
As notable investor Arif Akhtar emphasizes, by using a centralized exchange you are trusting that the exchange will not lose your money (whether from a hardware failure or other negligence), will keep your funds secure against theft or hacking, will not steal your funds internally, and will not go out of business. In short, centralized exchanges require you as the user to put a lot of trust into something that is currently unregulated and may not even be operating in the same country as you.
A better solution: ‘trustless’ decentralized exchanges
A decentralized exchange can provide an alternative solution when it comes to dealing with diverse digital assets and offer an alternative way to trade all cryptocurrencies. One of the primary reasons why a decentralized exchange offers a superior alternative is because it can leverage the underlying technology behind the currencies that it’s trading -- the Blockchain.
An exchange built on the Blockchain would be ‘trustless’ – meaning there would be no need to trust a single party to handle transactions because those transactions would be transparent. Because of this, it would be nearly impossible to ‘fake’ a transaction on a decentralized exchange running on the Blockchain.
The underlying transparency and security of the Blockchain technology behind a decentralized exchange would inherently ensure that the system is secure and operates with integrity to protect its user’s transactions.
Ideal model
Using blockchain technology a decentralized exchange can also be designed to not hold any customer funds. Instead, peer-to-peer transactions are possible through an automated process. Instead of a central “site” holding a user's funds, their money can be kept in an account until a trade is initiated. When a trade is initiated, it is between only the buyer and seller – so there’s no need to “trust” a central site to make the trade.
Moreover, the ideal decentralized exchange does not hold any user's’ tokens – thus preventing any theft or loss of tokens – and could perform trade requests instantly if there is enough liquidity in the system. This is in sharp contrast with current exchanges that not only require several minutes for a transaction to complete but can also malfunction during that time period – resulting in severe consequences, such as a loss of funds.
In addition, they can be created within a sound legal framework to protect a user's’ privacy by not requiring them to disclose their personal details, except if the exchange method involves bank transfers. This could prevent hacking of sensitive personal user information – which is all too common today with any system on a centralized server, let alone a currency exchange.
Still no switch to decentralized exchange
These are just a few of the reasons why we need decentralized exchanges - not only to trade currencies safely and securely but to address a number of other issues that will continue cropping up as the cryptocurrency space grows. The basic idea of a decentralized exchange is one that never holds users’ money. Instead, users know that their funds are safe in their accounts until they initiate a trade.
So why hasn’t everyone made the switch to decentralized exchanges yet? The answer is that decentralized exchanges are still relatively unknown, mostly because their interfaces are not as user-friendly as platforms like Coinbase.
In addition, most existing decentralized exchanges are not friendly to mainstream users who have limited knowledge about the Blockchain and cryptocurrency technology. However, as the general public's perception of cryptocurrencies continues to change, and exchange malfunctions and hacking headlines continue to grace our news feeds, there’s no doubt that decentralized exchanges will continue to rise as one of, if not the most, powerful ways to trade a diverse portfolio of cryptocurrencies safely and securely.
Loi Luu is a researcher working on cryptocurrencies, smart contract security and distributed consensus algorithms. He is also a regular speaker at Bitcoin and Ethereum workshops.