Are Decentralized Exchanges Ready for Mass Adoption?
Bitcoin and other cryptocurrencies were created to offer an alternative to fiat currencies, which are controlled by governments and other central financial institutions. With cryptocurrencies, the decentralized nature of the digital currency meant that they were controlled by the community instead of a central authority. As such, the idea of cryptocurrency became linked to decentralization. A decentralized currency does not require trust to be placed in a central authority, such as a bank controlled by the government. Even today, despite many cryptocurrencies not possessing a fully decentralized structure, the idea that cryptocurrencies should not belong to one centralized source remains a core tenet of the crypto community.
The main combination of decentralization and centralization can be seen with cryptocurrency exchange platforms. Centralized exchanges currently outshine decentralized exchange platforms in the crypto trading industry. It seems intrinsically dissonant for a fully decentralized cryptocurrency to be traded on a centralized exchange platform. However, the sheer volume of trades coupled with the extensive list of popular trading pairs continues to draw traders toward centralized exchange platforms.
The Popularity of Centralized Exchange Platforms
Centralized exchange platforms may have gained their popularity by mimicking what crypto users already know, namely the stock market and Forex exchanges. Traders have become accustomed to using certain advanced trading techniques, such as stop loss or margin trading, and want to trade cryptocurrencies using the same techniques. However, cryptocurrencies differ from stocks on a foundational level. The different may seem small but is quite significant. With cryptocurrencies, the owner is the entity which possesses the coin’s private key. With centralized crypto exchanges, users place their coins on the exchange by entrusting the private keys to the exchange. If an exchange is hacked or folds, the coins are lost and cannot be recovered by the user.
The losses suffered in the Mt. Gox incident in 2014 and the Bitfinex hack in 2016 are just two events that illustrate what can go wrong when private keys are entrusted to centralized exchanges. These events, and others, have shown the need for decentralized exchange platforms.
The Rise of Decentralized Exchange Platforms
A decentralized exchange platform (DEX) is one that allows individuals to maintain full control of their private keys and make transactions in a direct, peer-to-peer manner. On a centralized exchange, users are required to complete Know Your Customer (KYC) verifications, in addition to other identification procedures, before being registered to the exchange. In contracts, a DEX is a trustless platform in which users are not required to complete KYC verifications or lengthy registration processes. Trades are made using proxy tokens via multi-signature escrow accounts. This also allows DEX users to enjoy anonymity, unless a trade involved a bank transfer. In the case of a bank transfer, the party’s details are revealed only to the person they are buying from or selling to. While the increased privacy may seem like a benefit, it also poses a potential problem. Because decentralized exchanges require so little identification verifications from users, it becomes difficult to subpoena the exchange or any of the users, should a user encounter a scammer or other nefarious individual.
With centralized exchanges, there is a single point of failure; if the main server of the exchange goes down, then the platform cannot be used until the server is restored. With a DEX, there is no single point of failure. A DEX is hosted over a distributed network of nodes, reducing the risk of attack or server down time. By decentralizing the hosting of the exchange, decentralized exchanges become difficult to shut down by a government or other controlling power.
While there are a lot of positive aspects of decentralized exchanges, there are also some downsides to using such an exchange platform. A decentralized exchange represents an idyllic concept of decentralized currencies being exchanged over a similarly decentralized platform. However, current technology is not advanced enough to allow the DEXs that are running to attract the majority of crypto traders. Many decentralized exchanges are either still in their infancy or still being tested.
Current DEXs only allow for very basic trading to occur. They are known for being less user-friendly than centralized exchanges, and face scalability issues. When compared to centralized exchanges, decentralized exchanges are much slower. For example, Binance is capable of processing 1.4 million orders per second. IDEX, a decentralized exchange, can only process between 20-50 orders per second.
Many crypto traders choose not to use DEXs because they are unable to trade their desired pairs on the DEXs available today. The trading volume on these DEXs are very low, as compared to centralized exchanges, and raises concerns regarding the level of liquidity of these exchanges. In addition, because there is no central entity overseeing the exchange, finding a resolution to issues a user might encounter on a DEX is difficult.
The challenges of a decentralized exchange are not the only things that deter users. Another barrier, especially for new investors, is that fiat currency is not widely used and many of these types of exchanges do not support any use of fiat currency.
Current Options for DEXs
There are some decentralized exchanges that are up and running. OasisDEX is one such exchange and is a Dapp built on the Ethereum blockchain. Created by MakerDAO, OasisDEX is currently in its alpha testing phase. With OasisDEX, users can trade the pairs ETH/DAI, MKR/ETH, and MKR/DAI after creating an account with MetMask.
With OasisDEX, all orders are made on-chain and directly between users. One negative aspect of this DEX is that the transactions are known for being slow and expensive. Every action, from transferring crypto to cancelling orders, requires gas. Moreover, this DEX is vulnerable to front-running, as users can pay more gas in order to have their transaction mined faster.
Another exchange platform aims to solve the issue of expensive and slow transactions of fully decentralized exchanges with a hybrid model. IDEX offers cheaper transactions, faster order placement, and no front-running. Orders are booked off-chain but matches are made by the exchange. Once a match is made, a smart contract is used to settle the order. IDEX validates each transaction before submitting it to the Ethereum network. With IDEX’s hybrid model, coins are kept off the exchange and in the control of the user. The exchange is compatible with ERC-20 tokens and has one of the largest trading volume of current decentralized exchanges.
Will DEXs Gain Traction?
Centralized exchanges are also looking at how they can benefit from a partially decentralized structure. This past June, Huobi announced that it has begun developing the Huobi Chain Project. The Huobi Chain Project will be a decentralized autonomous organization (DAO) and will eventually be folded into the exchange. Huobi does not plan to be 100% decentralized but believes there is a benefit to finding the proper balance of centralization and decentralization.
Other technologies, such as the CounterParty protocol, act as a smart contract layer for transactions. When trades occur using the CounterParty protocol, funds are held in a decentralized escrow service until the order is matched. Protocols such as this, along with other technologies such as the Atomic Swap, will allow decentralized exchanges to develop further.
While currently, decentralized exchanges are not the preferred exchange platform of the crypto community, they may well represent the future. Once the right technologies are developed that can fully support DEX platforms, these exchanges may be more widely used.