The primary innovation of cryptocurrency is the existence of a form of digital money that exists independent of any centralized operator. Despite the fact that this decentralization is the main selling-point of these assets and the underlying technology, many still choose to store their digital assets on centralized exchange platforms and wallet providers such as Coinbase.
Arguably, this defeats the purpose of cryptocurrency—why bother using a decentralized form of money if you’re going to entrust it to a centralized third party anyway? There are certainly situations where having a third party maintaining custody of digital assets is safer than “being one’s own bank,” especially for those using cryptocurrency as an asset class to invest in, those without technical knowledge, or institutional investors who must have a qualified custodian safeguarding their assets.
Aside from the broader ideological considerations regarding the departure from decentralization, there is another problem that centralized exchanges face—they are massive targets for cyberattacks, hacks, and theft. The solution to this problem yet again lies in the blockchain, the distributed system that underpins digital currency systems.
Decentralized exchanges are autonomous trading platforms that exist within a distributed computer system. Just as it does in a digital currency system, running on a distributed network solves the aforementioned problems of centralization—an exchange operating on a blockchain doesn’t have one single point of failure for hackers to target, nor does it require trust in a third party. Some of the most popular decentralized exchanges include Waves, 0x, and IDEX.
There are, of course, tradeoffs involved. Centralized exchanges are far more efficient, expedient and easy to use than decentralized exchanges, and they often have more advanced trading tools such as limit orders.
Also, with a centralized exchange run by a company, there are (in theory), resources you can appeal to if you have trouble—i.e., customer service at the exchange (which is notoriously laborious and unhelpful across all crypto exchanges); or, for more serious issues, one could bring legal action against the company running the exchange through the court system.
If an exchange were truly decentralized the way Bitcoin is decentralized, then there would be no such possible recourse—you can’t sue Satoshi. This is not to be ignored—if someone manages to trick the automated system they could drain the entire exchange, leaving customers with nowhere to turn. A program is only as secure as its code, and small programming oversights can lead to catastrophe when lots of money is on the line.
Case in point,The DAO hack. The DAO, also known as Genesis DAO, was a decentralized autonomous organization built on Ethereum that sold its own tokens to investors for Ether, and then was supposed to invest that Ether in startups building on Ethereum. Essentially, The DAO was supposed to be an automated investment management firm.
Unfortunately, due to flaws in The DAO’s code, an attacker was able to repeatedly pilfer The DAO’s funds, stealing a total of 3.6 million Ether. This failure divided the Ethereum community to the point where a hard fork was necessary to roll-back the Ethereum blockchain and return the stolen money to investors. This hard fork created another cryptocurrency, Ethereum Classic.
A decentralized exchange is another form of decentralized autonomous organization, and as much as we might like to put The DAO heist to rest, it does teach us an important lesson—it takes more than decentralization alone to secure people’s money.
Recently, a partially decentralized exchange operated by an Israeli-Swiss cryptocurrency company calledBancor was hacked for$13.5 million worth of various digital assets. According to Bancor, an attacker managed to compromise a wallet belonging to the exchange used to upgrade smart contracts.
I refer to Bancor as a “partially decentralized” exchange because, while the trading function on the platform is operated autonomously by smart contracts, the platform is controlled by a single company. In response to this hack, the company proved how much power they have over the platform by freezing some of the stolen assets.
Whether one agrees or disagrees with the company’s decision to freeze the tokens (or even to build in the ability to freeze tokens initially) having this ability prevents the exchange from being considered truly decentralized.
Charlie Lee, the creator of Litecoin, said onTwitter, “A Bancor wallet got hacked and that wallet has the ability to steal coins out of their own smart contracts. An exchange is not decentralized if it can lose customer funds OR if it can freeze customer funds. Bancor can do BOTH. It's a false sense of decentralization.”
For a project to be truly decentralized, it can’t depend on or exist to benefit one single firm. If decentralized exchanges do become the future of crypto trading, it will most likely be the grass-roots, bottom-up platforms that prosper, not single-firm-operated semi-decentralized ventures.
About the author
Cameron Carpenter is a student of economics and computer science at Sarah Lawrence College in Bronxville, New York. He is the President and Portfolio Manager of Gryphon Capital Management, a student-run investment firm. In his spare time, Cameron enjoys reading and playing chess.