Blockchain Weekly Front Page: Decentralized Exchanges (DEX)

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The Blockchain Weekly Front Page is a CXO level briefing. Our mission is to serve the mainstream business community by selecting one major theme in the Blockchain Economy each week and three news stories to illustrate that theme. This is all you need to know, each week, jargon free for CXO level business leaders and investors who will use this technology to change the world, in your email inbox each Monday at 7am CET. 

For more on the format please click here.

Last week our theme was “Bridge to Blockchain mainstream adoption via the next bull market”.

There is no doubt that centralized exchanges (CEX), such as Coinbase and others, helped us reach this point. Centralized exchanges have been an important stepping stone in the development and adoption of cryptocurrencies.

Centralized exchanges are easy for new digital currency traders and some act as gateways, which allow fiat to crypto transactions. But philosophically, these centralized platforms couldn’t be further apart from the decentralized nature of blockchain and cryptocurrencies.

There are four main issues with centralized exchanges:

  • Trust: The root problem with conventional currency is all the trust that’s required to make it work. Satoshi never envisioned centralized exchanges.
  • Personal Documents: Centralized exchanges often require personal information and proof of identity, in order to deposit or withdraw to and from the platform.
  • Security: With a single point of entry, it means they are accessible to hackers easily. If something goes wrong, on a CEX could end up losing all your crypto.
  • High fees: Many well-known exchanges charge anywhere between 0.20% to 3% in fees, whereas a decentralized exchange mostly requires a small fixed fee, or in some cases no fee.

Today the bulk of cryptocurrency trading takes place centralized exchanges, yet more than 30 of them have been hacked, since 2013. According to ConsenSys: “99% of cryptocurrency transactions still go through centralized exchanges; this trend is expected to be reversed in the coming years.

Currently, there are over 200 exchanges, compared to 70 exchanges in March 2015. Every day, billions are being traded on cryptocurrencies exchanges. Centralized exchanges generate massive profits from trading fees. In exchange for their services, traders are charged different fees, such as trading fees, withdrawal fees, deposit fees, etc. The top 10 exchanges generate as much $3 million a day in fees, according to estimates by Bloomberg.

The biggest problem for centralized exchanges is security. There are lots of examples of high profile thefts, the biggest being Mt. Gox in 2014, when 850,000 Bitcoins belonging to customers and the company were stolen, an amount valued at more than $450 million at the time.

Decentralized exchanges (DEX) are gaining popularity, because they enable users to trade peer-to-peer in an automated way and ensure that funds are not vulnerable to thefts.

We are already seeing this shift take place. In fact, two of the largest centralized exchanges are planning on launching decentralized versions of their platforms.

Bithumb, currently the world’s sixth largest by daily traded volume based on CoinMarketCap, will launch a decentralized crypto exchange in 2019. Bithumb is planning to use R1, a decentralized exchange protocol that was developed by OneRoot Network.

The Bithumb announcement follows that of  Binance, which is also set to launch a decentralized exchange by 2019. Binance CEO, Changpeng Zhao, on an interview at CNBC’s Crypto Trader (youtube video), said  that he believes decentralized exchange is the future of the crypto market:

“I believe that decentralized exchange is the future. I don’t know when that future will come yet. I think we’re at an early stage for that so I don’t know if it’s a year, two years, three years, or five years. I don’t know but we got to be ready for it”

Another key difference between centralized and decentralized exchanges is the middleman. On a decentralized exchange, a middleman doesn’t exist. Smart contracts power everything, and a decentralized exchange is able to operate autonomously. Smart contracts on a DEX, allow buyers to connect directly with sellers to trade, without the need for a third party.

In the case of DEXs, fees still apply to use the exchange, but they are often less than their centralized counterparts and in some cases zero.

In a recent article about Plutus, users can convert and spend their cryptocurrencies without paying any fees through their decentralized exchange. PlutusDEX is a decentralized exchange on the Ethereum network, that facilitates the trading of Bitcoin, fiat currency and their token, the Pluton. PlutusDEX allows users to purchase cryptocurrencies directly from each other on the exchange without paying any fees. I love a free lunch, but there are not free lunches in this world. As stands now, this platform is cost-efficient for users, especially when you compare it to other centralized and decentralized exchanges.

While decentralized exchanges offer more security and control, investing through a DEX is even more complex than investing through a centralized exchange. Most DEXs struggle with liquidity, and lack fiat payments.

Liquidity is a vital element for any of the marketplace. Trading volumes on decentralized exchanges are minuscule and there is always the risk that traders will not get the best price for their trades. Bancor, the most liquid decentralized cryptocurrency exchange,in the last 24 hours had less than a $1 million in trades, a very small fraction of the volume of other exchanges.

Theoretically, governments and regulators cannot shut down a DEX because it is decentralized. While centralized exchanges are scrambling to get licenses in order to keep running, for now decentralized exchanges don’t really have to. It’s difficult for regulators to hold these exchanges accountable, since traded funds never pass through a centralized wallet and the entire process is peer-to-peer.

Decentralized exchanges represent a very small fraction of trades, which is why they are not on regulators radar. But as their trading volumes grow, we can expect regulators to take notice and try to regulate their transactions.

While decentralized exchanges are relatively new, most market participants agree they will be a big part of the future. As we evolve from centralized to decentralized, transactions will get faster, fees lower and security higher. Centralized exchanges dominate the market, but as DEXs mature they will become an appealing alternative and both will co-exist, each fulfilling its own unique purpose.

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Ilias Louis Hatzis is the Founder & CEO at Mercato Blockchain Corporation AG. He writes the Blockchain Weekly Front Page each Monday.

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