Background
Unfortunately, the cryptocurrency space has been plagued with numerous headlines about some large crypto exchange losing millions of their customers’ funds due to a hack. For an industry that places so much emphasis on removing middlemen, how can we give up so much power to large central entities?
When Bitcoin first gained popularity, there was an increasing amount of demand from users to trade dollars online for cryptocurrency. At that time, the only way for users to do so was to send their dollars or bitcoin to an online exchange operated by a central entity. The important factor here is that the central entity took custody of its users’ funds. The user would send Bitcoin to the exchange, the user then would be credited Bitcoin in the platform which they could trade for dollars, and then they could withdraw those dollars back to their bank account. But throughout the course of this transaction, the user never actually owned the digital asset, the exchange did.
Understanding The Centralized Exchange
There are numerous of centralized exchanges available to retail investors today, but a much smaller subset of these exchanges are properly regulated, not to mention trustworthy and reliable. Companies like Coinbase have pushed the space forward and newcomers like Binance have raised the bar for the alt-coin trading experience, the industry still suffers from constant hacks and malicious acts.
The main issue with centralized exchanges taking custody of user funds is that they expose investors to massive amounts of counterparty risk. In the case of an hack or theft, the exchange can’t do anything to retrieve the funds. If a user had their money stored on a centralized exchange during that time, their funds are gone forever. Similarly, since its widely known that large centralized exchanges are storing millions in user funds, they become enticing honey pots for hackers seeking a payday. Overall, storing money on a centralized exchange forces investors to take on additional risk outside of the existing volatility and regulatory risk associated with crypto assets.
Centralized exchanges are also inefficient in terms of liquidity. Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Market liquidity refers to the extent to which a market (such as Bitcoin or Ether) can be bought and sold at stable prices.
Each exchange has its own order book even though the types or orders are similar across nearly every crypto exchange. Limiting a marketplace to a single order book stymies market efficiency and price discovery.
Lastly, centralized exchanges operate opaque data silos. There is little transparency into how they operate their exchange, which often leads to nefarious behavior as there are no checks on their power.
Asset Exchange Meets Decentralization
Luckily for investors and crypto users, we can apply the same characteristics that make Bitcoin secure to exchanges. In Bitcoin, users always retain custody of their funds, it’s one of the factors that makes Bitcoin so desirable. Assuming you’re the only one with access to your private key, your Bitcoin can’t be seized or stolen.
By definition, A decentralized exchange or DEX is an exchange 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.
How Does It Work?
This system can be achieved by creating proxy tokens (crypto assets that represent a certain fiat or crypto currency) or assets (that can represent shares in a company for example) or through a decentralized multi-signature escrow system, among other solutions that are currently being developed.
When you send someone else Bitcoin, the protocol is essentially making sure that your private key actually owns the Bitcoin you’re trying to send. We can apply the same model to any Ethereum-based exchange. When a user submits an order, Ethereum can verify that their private key owns the rights to that asset. We can use smart contracts to match specific buy orders with sell orders that meet each other’s criteria. All of this can be done peer to peer, without the need for a centralized intermediary.
This has a number of key benefits including:
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- Self-Custody: Users always retain custody of their funds. Exchange hacks are impossible as there’s no central entity storing user funds.
- Permissionless: No centralized entity can deny a user access to their exchange. All that’s necessary to access a decentralized exchange is an internet.
- Trustless: No central entity can roll back the order of transactions. Once a trade is confirmed onto the blockchain, it’s final.
