Shortfalls of Decentralized Exchanges
Why fully decentralized exchanges are not a solution for the crypto-currency market
There are three types of cryptocurrency exchanges: centralized, decentralized and hybrid exchanges. In centralized exchanges, orders and trades are recorded off-chain on a private database. While this solution is used in the mainstream financial world, it creates, in the cryptocurrency market, counterparty and operational risks such as hacks and thefts (i.e. Mt. Gox and Bitfinex scandals) that are not bearable for institutional investors. In this article, we describe what decentralized exchanges are and why they are not a viable solution to the problems created by centralized exchanges.
A decentralized exchange is a marketplace that matches buyers and sellers on its platform and facilitates their transaction on a decentralized ledger or blockchain. Trades occur directly between users (peer to peer) through an automated process put in place by the exchange.
To do so, proxy tokens — like USDT — are used to replace non blockchain native currencies on the exchange in order to be able to transact in a decentralized way. Fully decentralized exchanges have existed since 2013 with MasterCoin and Counterparty. The concept of decentralized exchanges is attractive, as it allows users to eliminate any counterparty risk linked to a centralized exchange, which can tamper with its clients money and manipulate the market prices.
However, several issues arise when trading on decentralized exchange:
I. The latency and the network costs are too high
Because transactions are recorded on a blockchain, the validation time can be long (it can go up to 10 hours on the bitcoin blockchain) and the network fees are often high. For instance, as of January 2018: the network fee for BTC was $30. As this fee is not linearly dependent from the amount transacted, that means that small transactions (Between $0 and $1000) show high transaction costs.
II. Decentralized transactions between different blockchains are not possible
Transactions on a decentralized exchange can only occur intra-chain. For example, on Ethereum-based decentralized exchanges, users can only exchange on-chain ETH or tokens emitted on Ethereum.
As of now, pairs like ETH/BTC, LTC/BTC, XRP/BTC or BTC/USD are not tradable on a fully decentralized system since there is no vector to transfer information from one blockchain to another on a fully decentralized system. Projects like BTC Relay or ETH+ZEC do exist and aim at interconnecting different blockchains together. However, they are still in development stage.
Moreover, the concept of a cross chain bridge suffers from a major drawback: when you combine two different chains, the security of the resulting system is at the level of the weakest chain. Fundamentally, this makes cross-chain decentralized exchanges only possible with chains with the same level of security.
III. Volumes and Liquidity are low
According to Coinmarketcap.com, the volume of intra-chain trading represents less than 2% of all transactions per day. Moreover, cryptocurrencies listed on decentralized exchanges show a very low liquidity: there are much less orders placed than on centralized exchanges either because of the inconvenience of trading in such a marketplace (network fee & validation time) or simply because currencies available on these exchanges are not those on which focus most of the investors.
IV. It is not possible to deposit and withdraw fiat currencies
We, at LGO Markets, believe that deposit and withdrawal are important functionalities that must not be overlooked when trying to capture market shares. A lot of potential investors don’t own cryptocurrencies yet (in particular institutional investors), and need to deposit and withdraw fiat money on an exchange in order to buy and sell cryptos. Decentralized exchanges do not offer these kind of functionalities yet.
Centralized exchanges have the benefits of being fast and easy to implement. Even though they are the norm in the non-crypto financial world, time has proven that centralized crypto-exchanges aren’t a reliable structure — or at least not enough for institutional investors. Additionally, one could argue that centralizing the exchange of cryptocurrencies defeats the original purpose of the blockchain technology.
Decentralized exchanges respond to this lack of transparency and auditability by recording orders and trades directly on a blockchain. However, this solution is not scalable, fast, cheap and practical enough to become the industry standard. LGO Markets offers an hybrid solution, gathering the best of both centralized and decentralized worlds.