Decentralized Exchanges — Far More Disruptive Than You Think

I’ve noticed a lot of discussion lately around what exactly makes something like Coinbase a centralized exchange and what exactly the decentralized vs. centralized debate is all about. A common misconception is that it’s only about whether or not an exchange keeps custody of your crypto, but that’s a very narrow definition and there’s actually a far more disruptive and subversive movement happening around decentralized exchanges (DEX). Admittedly, it doesn’t help matters that terms in the cryptocurrency space can often be jargon-y, confusing, and sometimes mean more than one thing depending on the context. So herein lies my attempt to provide some (simplified) clarity and make the case for a bigger DEX picture.

Centralized vs. Decentralized = Who Has The Power?

In the cryptocurrency/blockchain space, when we talk about centralization vs. decentralization, we are usually talking about who has authority and power on a network. Oftentimes we are talking about hashing power or consensus authority e.g., Bitcoin centralization and security if a few mining pools collectively control more than 51% of the hashing power.

This is because the more decentralized a blockchain network, the harder it is to achieve 51% control through collusion or conspiracy, and therefore, the more secure and trustworthy the network. In the case of exchanges, we are also talking about who controls the market data feed and the matching engine, because whoever controls those things controls the ability to grant special access and make or break fortunes.

But before we talk about decentralized vs. centralized exchanges, including how they work and the trade-offs between them, it helps to understand why custody of cryptocurrencies is not the whole story behind (de)centralization.

Wallets != Centralization/Decentralization

A common definition is that centralized exchanges are ones that take custody of cryptocurrencies on behalf of users and decentralized exchanges are ones where users manage their own cryptocurrencies — but that’s really very narrow and centers around online vs. offline “wallets.” It’s important to note that the wallet debate isn’t about power and authority, but rather about ease of use vs. security. To better illustrate, it helps to understand a couple of things about crypto wallets.

The first is that nobody holds your crypto — not you, not centralized exchanges, not banks or other institutions. Or more accurately, everybody holds your cryptocurrencies, because they only exist as entries in distributed ledgers, a copy of which is maintained by every node on a network.

The second is that the ability to spend or transfer your crypto is dependent on one thing and one thing only: possession of the secret key that “unlocks” it. A wallet is simply a device that securely holds the secret key to your account — i.e., it doesn’t hold your cryptocurrencies, it holds the secret keys to spending your cryptocurrencies. Whether you hold onto your secret keys or entrust them to a 3rd party is a matter of convenience and security.

Wallets come in two main flavors:

• Online (sometimes called “hot”): operated by a 3rd party, e.g. Coinbase, where your secret key is kept on a 3rd party server and accessed with a username and password; very easy to use, but if the 3rd party doesn’t practice good security, your secret key might be stolen
• Offline (sometimes called “cold”): your own software/hardware/piece of paper/brain that holds your secret key; harder to use, and if you don’t practice good security, your secret key might be stolen

There’s a very lively debate about whether the convenience of online wallets is worth trusting a 3rd party with your finances, but like most online financial accounts, it comes down to the security measures (and insurance policies) of the online wallet you use, and there is a very strong argument that long-term mainstream adoption will only occur through online wallets. There’s also a strong argument that people tend to overestimate their ability to practice good security, and that offline wallets might not be all that more secure in practice. But while this debate is important, there’s a much more important debate going on around centralized and decentralized exchanges.

Centralized/Decentralized Exchanges — Who Controls What

As mentioned previously, the central question of the decentralization debate, at least in regards to exchanges — whether crypto, stocks, futures, or any other asset class — is (or at least, in my opinion, should be) whether the order book, data feed, and matching engine are centrally located and/or centrally controlled, or whether they are decentralized, often by running, in whole or in part, on a public blockchain — that is the exchange itself runs on a blockchain, rather than just transacting in blockchain-based assets.

Centralized exchanges have a couple of technological upsides — they tend to have very fast transaction times and very fast data feeds. Think high-frequency trading. They also tend to be physically located in a single data center and controlled by a single authority — this means that an advantage can be gained by simply locating as close as possible, and most centralized exchanges will sell you physical proximity (for a hefty sum). This also means that one entity creates and controls the rules of the system and we must rely on regulation (often self-regulation) to ensure fair play. What makes something like Coinbase different than the NYSE really comes down to asset types, and technologically they are more alike than different.

Decentralized exchanges (DEX) are the opposite — order books, data feeds, and matching engines are maintained in a decentralized fashion without a single physical location or source of origin, with the rules enshrined in publicly auditable software and executed by the network. It’s still very early in the development of DEXs and there are many variations in existence (and even more in development) achieving varying levels of decentralization, but a consistent theme is that DEXs provide a more level playing field with more democratic access to data, order matching, and rule creation. Depending on the details of how a DEX operates, its also possible that there may be less need for regulation, or that a system will lack any central entity that could be regulated, and security and fairness will come in the form of audited source code. And depending on your view of high-frequency trading, the tradeoffs in terms of slightly slower markets might not be a tradeoff at all.

If you’re curious as to how a DEX operates, we can loosely categorize them into one of three flavors:

• Direct P2P: operate purely peer-to-peer with only a simple order book and no matching engine, with parties making direct transactions with each other (sort of like the digital equivalent of an open-outcry trading pit); recent trends tend to focus on helping buyers and sellers find each other and/or maintaining privacy and anonymity
• Offline Order Matching: maintains a record of all transactions, including open and matched orders, on a blockchain, but the matching engine runs off-blockchain with varying levels of (de)centralization; recent trends usually focus on trying to bring some of the benefits of decentralization to this more centralized model of order matching
• 100% Blockchain: everything, including the matching engine, occurs on the blockchain in a decentralized fashion, which is the holy grail of DEX; recent trends focus on solving the technical challenges of running everything on a blockchain, thus far with limited success (most blockchains really aren’t designed to operate financial exchanges)

Note that there’s no technological reason that DEXs can’t provide an online wallet as an ancillary service — its just a service that holds your secret keys — and as projects mature we should expect that online wallet services for DEX exchanges will start popping up to provide better user experiences.

Wrap-Up

Ease of use/rate of adoption vs. security/custody is an important debate, but when we talk about DEXs in terms of decentralized control and operation of data and matching engines, we are talking about something that has the potential to be truly disruptive — a reimagining of what an exchange is and who owns and controls them, with the power to truly democratize financial markets. That’s a lot bigger than who has custody of your cryptocurrencies.

Disclosures

I own small amounts of BTC and ETH, and I am part of a team that has been working for the last year (in stealth mode) on an open-source blockchain for DEX financial markets.