Tom Goldenberg is a senior engineer at BCG Platinion | MAYA Design and founder of Blockchain Panel NYC. The views expressed here are his own.
Cryptocurrency exchanges operate in a fluctuating industry that is bracing for change.
With changes in regulation and customer sentiment rapidly shifting, it is anybody's guess what will happen in the next two to five years.
Notably, a few big players – both centralized and custodial in nature – handle the bulk of trading volume for the $381 billion-worth of the world's crypto assets.
In general, we can classify exchanges into three groups:
- Custodial exchanges
- Non-custodial exchanges
- Decentralized exchanges (DEXs)
Of these, both custodial and non-custodial exchanges are "centralized." This means that orders are routed and executed by a closed, internal system. This is different from a "decentralized" exchange. In a decentralized exchange, smart contracts match and execute orders.
An estimated 99 percent of trading volume flows through centralized exchanges. About 73 percent of these exchanges are custodial. Custodial exchanges act as managers of their customers' crypto wallets. The most popular crypto exchanges are all custodial — Coinbase, Bitfinex, Gemini, etc.
Custodial exchanges such as Coinbase manage user assets through an internal ledger. This ledger maps each customer with the coins he or she "owns." Customers do not have direct access to the wallets where the exchange stores their assets. Only upon selling or transferring the assets does a user have control over them.
Concerns over custody
The most notable advantage of custodial exchanges is ease of use. A user can access any of their wallets by authenticating with a username and password. There is no need (or possibility) of securing a private key, an exercise that can prove tedious.
Yet, the centralized nature of these exchanges, along with the immature state of regulation, has provoked concerns. An estimated one out of every 16 bitcoin has been stolen. Once an attacker breaches a system and obtains the private keys to the exchange, all is lost. (Or rather, all that is not stored in "cold storage," without connection to the internet. More exchanges have been making sure that a bulk of their reserves are not connected to the internet, providing an extra layer of protection).
This, in a nutshell, is what happened in the infamous Mt. Gox hack ('14), the hack of Bitfinex ('15), and the recent hack on CoinCheck ('18). Besides the long history of hacks, all exchanges face concerns over price manipulation, reflected in the recent probe by the Department of Justice.
In summary, here are the arguments for and against custodial exchanges:
- Pros: Familiar interface, easy fiat-to-crypto, and better customer support
- Cons: Target for hackers, high fees, and lack of privacy
The concerns over custodial exchanges have prompted many to push for the use of decentralized exchanges. Take this tweet from Vinny Lingham:
"I'm 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 decentralized exchanges and this is a key theme I'm expecting in 2018."
A non-custodial exchange is still centralized, but with a critical difference. It does not manage users' wallets. Instead, it matches orders through an internal order book and takes a fee off of the top.
One of the most popular non-custodial exchanges is ShapeShift, founded by Eric Voorhees. As per Voorhees, the company averages $10 to $15 million in transaction volume and roughly 15,000 orders daily.
Non-custodial exchanges like ShapeShift, Evercoin, and Changelly offer users more security and privacy. But, they do not offer conversion from fiat currency to crypto. This has prompted several efforts to peg a cryptocurrency to the dollar.
Because non-custodial exchanges are still centralized, their internal mechanics are not transparent. One could argue that there is still the possibility for foul play. Additionally, non-custodial exchanges suffer from low liquidity, scaring away sophisticated investors.
This takes us to the state of decentralized exchanges (DEXs). Many in the crypto community are rooting for these to succeed.
"99% of cryptocurrency transactions still go through centralized exchanges; this trend is expected to be reversed in the coming years." — Nathan Sexter, Consensys
After all, part of the appeal of cryptocurrencies is the idea of a decentralized internet — a platform where no single party controls the data. In that case, why do centralized platforms control the exchange of crypto assets? This is often referred to as a "dogfooding" problem, or not practicing what you preach.
There are several operating DEXs matching and executing orders via smart contracts.
The Waves DEX, for example, is currently handling about $6 million of daily trading volume. Others are still in the development or testing phases.
The chart below tracks fundraising by some of the players in the space, including companies like 0x, which is building a protocol for DEXs:
On paper, DEXs are a perfect solution for the concerns raised by centralized exchanges. They are fee-light or fee-less; they are transparent since the code can be inspected; they are more secure since you control your wallets.
But there are downsides to DEXs in their current state as well. Several of these mirror the challenges of non-custodial exchanges:
- Inability to convert between fiat currency and crypto
- Low liquidity
- Less interoperability than non-custodial exchanges. Inter-chain trading (i.e. BTC to ETH) makes up 98% of all cryptocurrency trading, as per coinmarketcap.com, 2018. This doesn't bode well for DEX's which depend on a single chain for trading.
Let's not forget that smart contracts are hackable, too. Take this quote from Jacob Woods:
"Although trusting a third party isn't necessary, a lot of faith is put on the smart contract itself. Money can and has been stolen from decentralized exchanges despite the fact that many community members considered them unhackable."
There is a general consensus in the crypto community that DEXs will take on a more prominent role. Even Coinbase's head of communications, Megan Hernbroth, has this to say:
"Decentralized exchanges are complementary to and important for the development of the ecosystem by acting as a middle ground."
It is also widely accepted that custodial exchanges have a role to play in crypto's future. Eric Voorhees contends that for many people, custodial firms are more convenient.
"I expect the banks of the future to look a lot like Coinbase, and I say that as a compliment to Coinbase. Crypto gives everyone the option to hold their own money, which is great, but that doesn't mean everyone should, nor that everyone will want to."
There are also those who believe that the future of crypto will contain a hybrid of centralized and decentralized services.
Peter Smith, CEO of Blockchain, argues that allowing centralized exchanges to do what they are good at — support, compliance, and banking — while moving private keys back into the hands of customers, would "drive value for [the] entire industry."
It seems inevitable that DEXs will continue to rise in popularity, but doubtful that they match the scale of custodial exchanges anytime soon. If customer awareness of privacy and security continues to grow, we may witness more custodial exchanges offering hybrid solutions as well.
With regulatory uncertainty looming over the industry, incumbents should not feel too comfortable at the top.
Exchange image via Shutterstock