Future of Crypto Trading: Decentralized Exchanges. Distinctions from Centralized Ones
What are centralized exchanges?
Exchange is a market for trading assets like shares or cryptocurrencies. Generally exchanges are centralized. Among the most well-known ones are New York Stock Exchange (NYSE) and the London Stock Exchange (LSE).
But what does “centralized” means?
It means the asset orders are directed to NYSE, for example, and get compared with the corresponding order at the same price. All orders take place at some specific spot as they are routed via NYSE.
Let’s say, you would like to buy bitcoin for USD. For doing so you have to transfer your money to a centralized exchange (like Coinbase) and then it will convert your dollars into bitcoin at the current rate.
What is problem with centralized exchanges?
There are lots of them with security being the primary one. We all know of numerous hacks and bitcoin hijacking. Centralized exchanges have other problems too from constant failures to high charges and insider trading risks.
What are decentralized exchanges?
Decentralized exchange is a market that functions without third party involved to store customers’ funds. Instead, trading happens directly between the users (peer to peer) in automatized process.
This system may be established by creating proxy-tokens or via decentralized escrow system.
Decentralized exchanges are aimed at solving almost all problems centralized ones have.
Data storage security
The largest vulnerability of centralized exchanges is that they’ve got online databases with private and public keys of their users. This makes them a perfect victim for hacking. Here are only few companies from a long list of those with cloud databases hacked: Deloitte, Uber, Dropbox, Equifax, LinkedIn, Docusign, OneLogin, BlueCross Blue Shield, Verizon and SEC(!).
If these large companies failed keeping clients’ private data from medical records to credit card information it seems a reasonable guess that some of centralized crypto exchanges will be hacked. There have already been such cases with Mt Gox, Bitfinex and Shapeshift.
Decentralized exchange eliminate these risks allowing its users go with no middlemen involved thus making the users responsible for data security rather than single keeper.
When integrating with hardware wallets like Trezor and Ledger decentralized exchanges provide for storing coins in cold wallets and at once trading them. This rules out large-scale hacks as there is no centralized cloud database to keep users’ private keys.
Server downtime problem
Every time prices for Bitcoin or Ethereum fluctuated dramatically, most of centralized exchanges had long dead time.
In November and December Coinbase had at least 30 downtime and delay incidents. Almost every time Bitcoin price sank the majority of users could not sell the coin until volatility came out.
Every time huge number of people conducts transactions total computational capacity of the system increases with the number of nodes rising.
Identity disclosure risks
Authorities of many countries have started regulating centralized exchanges for issues of taxation and monitoring recently, so they began asking their users to submit address, social security number, copies of passport, ID or driving license and utility bill before a user will be allowed to trade above few thousands of dollars. Obviously, all this data are at risk either in case of possible hack.
Decentralized exchanges do not require authentication by default. The only thing one needs for trading is a hardware or web wallet. Putting it another way, anyone may trade without logging in or having personal account so nobody will hijack your social security number or passport.
For the reason of huge number of documents centralized exchanges have to check its users manually which takes several days or weeks even. What is more, lots of exchanges charge commission for adding or withdrawing funds which demands additional checks.
With lacking authentication and limits for adding or withdrawing funds decentralized exchanges do not counter a problem like this.
Most of exchanges have extra high duties. It makes up to 1.49% by bank account or 3.99% by credit card at Coinbase in the USA. Most of other exchanges set 0.25% (Bittrex, Poloniex, GDAX).
Many decentralized exchanges like Waves shift to pretty small fixed fee system with a 100 000 dollar transaction costing few cents compared to 1490 USD at Coinbase and 250 USD at other centralized ones.
Price manipulation/ Insider trading
Centralized exchanges are often accused of conducting forward deals or insider trading.
There are no such problems with decentralized ones as order book is based on public blockchain. When order is transmitted, transaction is formed and sent to the network. Thus any party checking public blockchain will be at the same time informed of a transaction.
As for insider trading, decentralized exchanges try to avoid it in many ways, like listing every token ERC-20 as soon as it gets issued (like Ether Delta) or via open voting system for coin listing.
There are dozens of decentralized exchanges. 2018 is expected to see far more of similar platforms arising as recent burst of crypto activity has exposed all drawbacks of centralized exchanges.