Centralised vs decentralised cryptocurrency exchanges
You can buy or sell cryptocurrencies at cryptocurrency exchanges that are either centralised or decentralised. A key difference between the two is a matter of a middleman. A centralised cryptocurrency exchange has an intermediary and the decentralised exchange does not.
A centralised cryptocurrency exchange can be an online platform or app that allow you to trade cryptocurrencies against other cryptocurrencies or fiat currencies (currencies back by governments used as legal tender).
Consumers are used to that idea when it comes to online trading in other items. Amazon, Uber, Airbnb and Ebay are among the most popular examples of online platforms what are marketplaces bringing together one party with another.
Centralised like a bank
A centralised cryptocurrency exchange is similar to a bank because it has a middleman in whom customers place their trust to manage their money. Like banks, a centralised cryptocurrency will take care of your money and your account.
This generally means that many will have interface that allows for ease of use by a range of customers, from an absolute novice who may hold a couple of coins through to the professional day traders or institutions.
You trust them to exchange your cryptocurrencies for fiat or other cryptocurrencies. The exchange literally holds the key (private); allowing access to hardware wallets and eliminating a customer’s need, for example, to remember where they’ve kept it.
You can buy and sell cryptocurrencies paired either with other cryptocurrencies or with fiat be they USD, EUR, etc. However, while all exchanges allow trading of crypto pairs, not all exchanges will allow for pairing with fiat; although the more popular exchanges (such as Krakken and Coinbase) do have it as a feature.
But blockchain technology and the cryptocurrencies fuelling them are inherently decentralised and exchanges can be decentralised too.
A decentralised need
A decentralised cryptocurrency exchange (DEX) works differently in that trust is built into the system cutting out the need for a middleman.
Customers trade peer to peer using smart contracts (special protocols with all the information about contract terms, executed automatically, with transactions trackable, verifiable and irreversible) or atomic swaps (smart contract that allows exchange of one crypto for another without a centralised intermediary).
To distinguish themselves, some crypto exchanges may move beyond an exchange and offer a slew of other services to help set them apart. For example, OpenLedger is decentralised and offers exchange between cryptocurrencies and fiat as a way to drive growth.
Co-founder and CEO, Ronny Boesing explains the strategy of the now four-year old exchange that is essentially a blockchain one stop: “My partner and I set out to create an exchange able to compete with the most established exchanges at the time such as Bitstamp, BTC-e, Coinbase and Kraken, focusing initially on Europe. With an added fiat option, we had an increasing number of dedicated users joining the exchange.
“The fiat option is one of the biggest challenges to any exchange due to the fact that most banks will not accept any fiat initially coming from a crypto. It remains a hassle, but we believe we have finally found a bank able to handle our needs. With that came the ability to use numerous payment platforms and payment card options.”
Centralised cryptocurrency exchanges are not forts and can be assailed. Decentralised exchanges, by dint of their design, eliminate much of this threat since users have custody of their own assets. Increasing numbers are coming on stream in response to the security issues from their centralised counterparts.
Although, as Lucas Nuzzi, a senior analyst at Digital Asset Research commented in Bloomberg: “Many issues regarding the way Decentralized Autonomous Organisations are regulated, taxed and insured need to be solved. Having said that, it is remarkable that millions of dollars worth of digital tokens flow through these exchanges every month.”
In the meantime, popularity of cryptocurrencies and the proliferation of ICOs has been catnip for the criminally minded. Now known as cyber heists, these high-profile hacks have resulted in huge losses. In January, a theft at the Japanese cryptocurrency exchange Coincheck meant a record loss of more than $500m.
If a centralised exchange becomes compromised by a hacking crime it can seriously roil the markets. Mt. Gox exchange suffered in 2014 the largest cyber theft yet with reported losses of 850,000 bitcoins around $450m. At that time, when Mt. Gox came to a halt so did everything else. For example, payments stopped as merchants were stuck unable to convert their bitcoins to dollars when they needed to pay their bills in dollars.
It may have set off a string of exchanges building in redundancies, professional and security that were lacking at Mt. Gox. The more exchanges there are, the less likely for a single theft to create a crash, but there may still be major seismic waves.
CryptoCoinCharts show that the top three exchanges retain the biggest market share by volume in a 24-hour period Binance leads at 34% followed by Bitfinex at 27% and HitBTC at 10%. Howmuch.net, cost information site, provided a visual aid of the biggest scams using data from CryptoAware.org, which recently published a list of highly significant crypto hacks and scams.
Centralised cryptocurrency exchanges have a big hurdle to scale when it comes to security issues. They suffer the same setbacks that any organisation with a large amount of data will do, which is they are susceptible to attack through the internet linked digital wallet.
However, there is still a giant question mark about how to regulate a space that began in response in part to freedom from oversight. Regulatory risk remains high for centralised exchanges.
Major scams such as that at Mt. Gox highlight the necessity of working with regulators to build bridges to the traditional financial system as Jesse Powell CEO of Kraken, a digital asset exchange, underscored.
Powell, earlier this year, refused to come forward to answer a public request for information about his business posed by the then NY attorney general, Eric Schneiderman. Powell basically drew a line in the sand because he smelled grandstanding and hubris on the part of the attorney general. The US accounts for only 20% of Krakken’s business and to his mind regulators can take a seat at the table to discuss it, but are in no positon to make demands.
“This is the wrong kind of attitude to have we have to put our foot down somewhere we can’t just bend over backwards every time some random regulator anywhere in the world…comes forward”
Explaining his refusal in a recent Unchained podcast Powell says: “I saw it more as a deadline than a request. It came with a deadline of two weeks to produce this 40-point questionnaire and I felt like, my first reaction when getting that it was like this is a total slap in the face. Those are the words in my mind, turns out this guy is actually slapping people in the face (reference to the attorney’s scandal and subsequent downfall) in his spare time – allegedly.”
Powell said he was offended because an attempt to gain a BitLicence a few years prior that failed meant they had withdrawn from New York. They had also had no prior interaction with the attorney general. In addition, Powell said a lot of the information was also already available and pointed out that if regulators had questions there were usually less public means to ask them.
“It was a total publicity stunt rather than going to get help from your own government you are putting the burden on all of these exchanges to produce this. We all produce most of it back before the BitLicence emerged so New York has this information. A lot of it is on the web site and a lot of it is private and frankly the government doesn’t have a great track record of keeping this information private,” he added.
Getting a spine?
Powell was clear about his thoughts when it came to former attorney general Schneiderman. “I can’t stand bullies and I can’t stand hypocrites and this guy turned out to be both.”
“I wouldn’t have said anything if it wasn’t for other exchanges coming forward and saying oh this is great, we can work with the regulators and respond to this but I felt like this is the wrong kind of attitude to have we have to put our foot down somewhere we can’t just bend over backwards every time some random regulator anywhere in the world and in this case not even a regulator but law enforcement official comes forward and demands things on a deadline especially in a place we don’t even have service.”
Is it possible for centralised exchanges to face down demands from regulators and law enforcement alike? Powell’s reasons typify the fraught existence between exchanges and regulators. Exchanges, however, may not have a great many choices when officials wield a regulatory cudgel.
Around the world, there has ben a groundswell of either outright bans (as in China and Russia) or regulators have tried a softer touch, issuing warnings about the risks of investing in cryptocurrencies such as in US, Hong Kong and South Korea.
India is currently mulling over its official regulatory stance and has stated outright that cryptocurrencies are not considered legal tender or coin. Shaktikanta Das is a former secretary of economic affairs and a member of the government’s 15th finance commission and led the government’s first panel set up in April 2017 to understand and recommend regulations of cryptocurrencies. In an interview with Quartz, he said regulating them would be a tough task.
Costs of uncertainty
Das said: “Let us accept that it would not be possible to regulate it effectively. Because they will do transactions from their houses. You cannot enter every home to check what transactions are going on. So, I think this is a serious challenge, and this should not be allowed at all.”
Regulatory uncertainties could have propelled Kraken’s decision in April to suspend all exchange services for residents of Japan. The exchange had been operating in the country since October 2014. It said it was “impractical” to continue service for Japan residents citing costs.
Japan’s Financial Services Agency crackdown came after Coincheck’s hacking incident issuing on-site inspections of unregistered crypto exchanges which resulted in business improvement notices distributed to eight and the temporary suspension of operations at three.
Is decentralised an answer?
This question of regulation could spawn a new era, that of decentralised exchanges. According to ConsenSys, “99% of cryptocurrency transactions still go through centralized exchanges; this trend is expected to be reversed in the coming years.”
Vinny Lingham co-founder & CEO of Civic.com had this prediction on Twitter back in January this year: “I am almost certain we will see a top 25 crypto exchange fail or be shut down in the coming months. This will be the catalyst for the emergence of decentralised exchanges and this is a key theme I’m expecting in 2018”.
Decentralised exchanges are growing as an answer the ills bedevilling centralised exchanges. OpenLedger’s exchange saw a jump to more than 200,000 signed-up users and a daily average volume of $3m.
OpenLedger attributes this growth to the effort of establishing its currency transfer regime within the legal framework of Denmark, a member of the European Union (EU). The banking and card arrangements for accepting fiat currencies had to comply with laws governing anti-money laundering (AML); know your bank (KYB) and know your customer (KYC).
But as critics point out decentralised isn’t the panacea as it has a few barriers to scale as well such as a less friendly interface for some users. Even Kyber Network’s (a decentralised exchange) co-founder & CEO, Loi Luu admits to what may slow down the progress of DEX.
“Centralised exchanges are potentially unable to handle large volumes of users, touting decentralised trading platforms as a better alternative. However, decentralised exchanges are not as user-friendly as centralised options, and may not have the funds to support mass trading due to small numbers of users.”
DEX may provide better security but they are still evolving as a technology. As SingularX product manager, Ruben Carrion, elaborates on their relative youth recently, “DEX’s tend to be very bare bones, causing a very steep learning curve to new users, and there can be issues with speed and liquidity.”
Still there is a palpable shift as centralised exchanges make more room for decentralised. In the future, there won’t be a complete takeover perhaps but some predict a co-existence and, the breakthrough of hybrid centralised/decentralised models as decentralised models become more refined.