What is a decentralised exchange?
(Yes, I’m British, I spell it with an “s”)
I’ve found myself answering this question a lot lately, and I had assumed a decentralised exchange was a well known term. When the crypto and technology community uses the term Decentralised Exchange (or DEX) they mean something very specific.
To a policymaker or regulator, they tend to mean an exchange or other blockchain business that has no legal presence in any jurisdiction, or is simply peer to peer.
This could be concerning regulator folks because “nexus” (where most of your organisation resides or operates) is traditionally a basis for jurisdiction (who’s rules you’re subject to). If a security is offered to US persons, then it is expected to comply with US securities laws, for example. A service that purports to be nowhere (and everywhere) may appear to have trouble fitting into this framework.
Lets take it to the next level of detail, so we can understand what the risks might be. Here’s the three things we could mean by “decentralised exchange”, and their key differences:
1) Non Custodial Exchanges (peer to peer)
This would be a service like LocalBitcoins. These organisations are marketplaces that connect buyers with sellers directly. Unlike Coinbase or Kraken, where the exchange is in custody of the cryptoasset, the non custodial exchanges never hold the asset on their servers or service. They simply match a buyer with a seller and provide an element of discovery of bid / ask pricing.
Typically these organisations have not performed KYC / AML (or CDD) checks and may contend that this should not be required because they are not in the flow of funds . However, from a policy maker perspective, they have potentially an increased risk profile. The precise nature of these risks and how to mitigate them is work the Global Digital Finance community are actively developing through their AML and Code of Conduct working groups.
Importantly, there is typically a legal entity that is incorporated, that uses a “centralised” technology service such as Amazon Web Services to host their website, mobile apps and services. This technological centralisation is a key point to consider when using the term “Decentralised Exchange”. To a technologist, a non-custodial exchange is not decentralised. They also have a centralised management team.
2) Crypto to crypto exchanges
Examples here are Binance and Bitfinex. Typically, these exchanges do custody cryptoassets but do not allow fiat to crypto conversion. For a consumer who does not own crypto, you cannot on ramp to these exchanges, but assuming you already have crypto you can then trade on a centralised order book.
These organisations have differing levels of KYC / AML (or CDD) checks with some allowing up to 2 BTC (~$14,000 as of 5th August 2018) to be deposited pre-KYC. Many of these organisations are incorporated as legal entities although some have favoured incorporation and potentially regulation in smaller off-shore locations (e.g. Malta). Whilst these organisations typically sit outside the regulatory perimeter of major jurisdictions many of the tools developed to prevent, detect and report AML and CTF risks for custodial, fiat to crypto exchanges could be implemented by custodial crypto to crypto only exchanges.
Similar to Centralised non custodial exchanges, Crypto to Crypto exchanges typically sit on a number of “centralised” technologies and tech providers and would not to a technologist or to the crypto community be termed “decentralised exchanges”. They also have a centralised management team.
3) Decentralised Exchanges (DEX)
An example here would be Radar Relay. Built using the 0x protocol, Radar Relay uses the Ethereum platform as its underlying technology and runs as a series of smart contracts. In other words, there is no central point where the technology is stored, run or managed. Radar Relay has a team of open source contributors rather than a traditional incorporation structure.
It is important to know that these technologies are still early, low volume and very slow compared to all other types of centralised service. A small enthusiast audience do use truly decentralised exchanges, but their volume is tiny when compared to the rest of the crypto markets.
It is too early to say what the standard AML / KYC (or CDD) rules will look like in this arena, but there is no reason why a DEX could not implement rules or adhere to a code of conduct. Even though their “management team” does not have a clear nexus, they could still comply with global standards and local market regulations.
As an aside, this points to the potential for “decentralised market structure”. Which is an area of potential significant innovation from a resilience perspective. In addition, decentralised market structures have the potential to limit the systemic risk of FMI’s to be too big to fail (given they can be owned and operated by many parties at once).
Summary
This blog post highlights the need to be precise with language and focus on the actors and their activities. Whilst a crypto to crypto exchange, or a truly decentralised exchange (DEX) may appear to exist without a clear jurisdiction, many global standards and local regulations can be applied by these organisations. There is no doubt there will be new challenges and risks, but as always the devil is in the detail.
The detail drives the materiality of risk. Simple questions like does it have AML / KYC ? Is there a customer due diligence process? Can be yes and can be no. Not all crypto to crypto exchanges have poor controls but some do. There is no absolute “bad” organisational design or technology, but there are clear risk factors.
For a much more detailed view head to this overview by Manki Prasash
Global Digital Finance is actively reaching out to many such organisations to inform them of the work of the code and help bring further clarity to policy makers where helpful.
