The concept of a ledger, a public record that provides a permanent and immutable summary of all transactions, is one that has existed in human society for thousands of years.
When the age-old concept of a ledger was combined with online database technology that allows it to be updated in real-time by anyone, anywhere in the world — the blockchain was born.
A blockchain, therefore, is an online database of transactions that multiple parties can share — and everyone can trust.
At the moment there are three different types of blockchain exchanges — centralized exchanges, decentralized exchanges and hybrid exchanges which are (you guessed it) a hybrid of the two.
Each exchange is different and has its own properties, and it’s own pros and cons. In this article, we will take a look at these different types of blockchain exchanges, how they work and their advantages and disadvantages.
A Breakdown of The Exchange Landscape — October 2018.
What is a centralized exchange?
If an exchange is centralized — it means that you are trusting someone else to handle your money.
In other words, there is a trusted middleman who is handling whatever asset you might be trading. For example, when you use a bank you give over your money and ask them to hold it for you. The bank is a centralized organization with complete control of your money.
A centralized cryptocurrency exchange is similar to a bank in this way. You can store your money on the exchange and the currency will be in their hands. When it comes to global order books, centralized exchanges (as a rule) must receive permission from governments and (sometimes) banks to operate — which means that their order books are only available in the locations where they have received such permission.
Here are some examples of centralized cryptocurrency exchanges:
- Binance: Binance is an exchange that launched in 2017 and it already has the highest volume of any exchange. It is operating out of China and it is so popular that many altcoins move to Binance after they have their initial coin offering.
- Bittrex: Bittrex is another cryptocurrency exchange based in the USA and it is known for having an interface that is very easy to use for those who are new to cryptocurrency.
- Bitstamp: Bitstamp is another bitcoin exchange, based in Luxembourg. It allows trading between US currency and bitcoin cryptocurrency — allowing deposits and withdrawals for USD, EUR, bitcoin, litecoin, ethereum and ripple.
- Bitfinex: This is another one of the main long-standing cryptocurrency exchanges, in the top 10 for trade volume. It’s located in Hong Kong.
- Kraken: Kraken is a US based cryptocurrency exchange — the largest one in euro volume and liquidity.
Pros and Cons of a Centralized Exchange
- A centralized exchange is a lot easier for new digital currency traders to use because it does not require the user to setup his / her own (crypto) wallet.
- These types of exchanges can also provide additional advanced services for more professional clients, such as lending, stop losses and margin trading.
- It is easy to change FIAT (i.e. USD or EUR) into crypto-currencies (i.e. Ether or Bitcoin) because most of the companies allow deposits in FIAT (after you’ve been identified).
- Centralized exchanges are fast, they have their own servers and local databases which means they can transact in a most modern and fast way as i.e. they don’t relay on block-times.
- One of the main criticisms is that a centralized exchange goes against the decentralized world of the blockchain — by giving power to and trusting a third party / middleman.
- When an exchange is centralized, it means that the central organization controls all of your funds and you must perform all transactions through it. This brings a great risk as a hacker only has to hack the centralized server(s) of such an organization in order to get access to (all) customer funds. The history of hacked exchanges is therefore long and growing.
- Many centralized exchanges charge (high) fees for using them — on both sides. Meaning the traders pay fees for withdrawing and in most cases for trading. Where as the listening of a (new) Token is usually connected with tremendous fees. It’s not a surprise that Mr. V. Buterin has not so good feelings about them.
I definitely hope centralized exchanges go burn in hell as much as possible — Mr. Vitalik Buterin (July 2018)
What is a decentralized exchange?
In contrast to a centralized exchange, a decentralized exchange cuts out the middleman by creating a “trustless environment”. This allows you to make deals through smart contracts, so that crypto-currency (or token) is never handled by a third party. It is an exchange that is completely peer to peer — it does not rely on a third party service to hold the customer’s funds as these funds are secure in their own wallet.
In other words, with a centralized exchange you need to trust the central authority you are transacting with — as they will have access to your personal account information and your wallet. With a decentralized exchange you will deal directly with the other party — through the use of a smart contract. Also you have control over your wallet (and private key) and therefore over your own funds.
Here are some examples of decentralized cryptocurrency exchanges:
- IDEX: IDEX is a decentralized smart contract exchange that is Ethereum based. It allows for real-time trading and it is known for being fast and user-friendly.
- Bancor: Bancor is a blockchain protocol that allows users to convert between different tokens directly, rather than exchanging them on cryptocurrency markets. (It offers the opportunity to trade tokens that would otherwise be more difficult to exchange.)
- Oasis Dex: Oasis is a simple on-chain market for all token assets in the Maker registry.
- OpenLedger Dex: OpenLedger is a blockchain company based out of Denmark, also providing decentralized solutions for the crypto-market.
- Agora Trade: is a cross-chain, non-custodial, cryptocurrency exchange.
Pros and Cons of a Decentralized Exchange
- Decentralized exchanges reduce the chances of coins being compromised to an absolut minimum. Since they do not store any coins or private keys on the central servers.
- You will have full control over your user account, your balance, your login data, your wallet (private key).
- There will usually be no fees per transaction, or very little fees (gas cost of the transaction).
- Not Restricted by Law or Regulations: Not being restricted to one physical location, decentralized cryptocurrency exchanges are much harder to regulate or even shut down. The question remains if there is even a solid ground for them to be taken down.
- Any token can be listed and traded for free, even by the consumer (as long as the token smart-contract allows transfers between 2 parties without checking against a whitelist smart contract).
- Decentralized exchanges without a proper onboarding process (KYC / AML) can’t be regulatory compliant on token level, therefore will not be able to list and enable trade for security tokens. As security tokenholders need to be identified for many legal reasons most importantly being able to protect themselves (investor protection) and then are whitelisted (blockchain level).
- You are responsible for maintaining personal security over your own wallet or device. (In contrast to the bank-level security of a centralized exchange.) This means you are more vulnerable to locking yourself out of your money.
- There will usually not be a central support service you can contact in the event of service issues or complaints.
- Liquidity at most decentralized exchanges is low (not many customers) and orders on completely decentralized exchanges (meaning the order-book is also on-chain) are completed slowly (as it is related to the block time of the respective underlying Blockchain).
What is a Hybrid Exchange?
A hybrid blockchain exchange is often considered to be the “best of both worlds” as it incorporates characteristics of centralized and decentralized exchanges. A hybrid exchange allows an enterprise to have the benefits of blockchain — without the associated problems of a blockchain. It is considered to be the “next generation” of crypto trading marketplaces.
A hybrid blockchain exchange consists of a public blockchain that all participants take part in, as well as a off-chain, centralized element (i.e. the orderbook). Some of the main benefits of bringing together a private and public blockchain are improved privacy, robust security and faster transaction speeds. The order book is off-chain, because otherwise it would be too slow.
Essentially, the hybrid exchange offers the functionality and liquidity of a centralized exchange, with the trustlessness and security that a decentralized exchange offers.
Here are some example of hybrid exchanges:
- Radarrelay: Radarrelay is another peer-to-peer trading platform for Ethereum based tokens. It’s build on the 0x protocol (see below).
- XDC: Created by Singaporean company XinFin, this is a hybrid exchange that is trying to make the most of the power of both the public and private blockchains.
- Blockport: Blockport aims to be an end-to-end trading platform that addresses the problems it sees with current cryptocurrency platforms — such as poor usability, education and transparency (and high barriers to entry). They predict that if they can counter these issues with their approach, they will encourage more people to adopt cryptocurrencies.
- NEXT.exchange: This is a peer to peer trading platform that allows individuals to trade between crypto, fiat and other digital assets. They are an established Dutch company that is in line with regulations and compliances — so they are unlikely to ever go down.
- 0x protocol: This is an open-source protocol for exchanging ERC20 tokens over the Ethereum blockchain in a cost-effective and decentralized way. It is not entirely off or on the chain, it uses both approaches to deliver the best results.
Exchange Landscape Summary
For an overview of the three main types of exchanges, take a look at the chart below.
Why are there no truly regulated exchanges in triple A jurisdictions?
Although the blockchain sector is growing at a rapid pace, blockchain-related businesses are still largely unregulated in most countries. In fact, the use of cryptocurrency is often (unfortunately still) thought of as a mechanism to facilitate criminal activity.
This threat of criminal activity is exactly why blockchain needs regulators — so that it can be used for its many unique advantages without the risks. It is reasonable for the government to step in and curb the irrational or illegal selling and trading of cryptocurrencies.
However, every country has different regulations (or even non-existent) on cryptocurrencies / Blockchain at the moment — making things very confusing. Which is one of the main reasons why Blockchain (applications) hasn’t gone mainstream yet. Some countries refer to it as an investment tool, others compare it to fiat money or securities and some nations have banned cryptocurrency altogether.
Many countries around the world are still generally quite unreceptive when it comes to cryptocurrencies and the blockchain. Other countries try to get a leading position being very easily issuing licenses (i.e. Vanuatu, Malta, Estonia) but still even the exchanges who have this license don’t feel comfortable to list and trade security tokens.
Of course, it’s important to note that blockchain is essentially a distributed database technology and it requires little regulation. It has applications in financial services cryptocurrencies and fundraising which might necessitate regulation — but the focus should be on the applications of the blockchain, not the technology itself.
For example, if a blockchain solution is used in the gambling industry, it should be regulated by gambling laws. Or if a blockchain solution is used to enable easy trading of securities (security tokens / asset backed tokens), the existing financial laws & regulation should apply to centralized platforms.
How come existing launch platforms don’t do Security Token Offerings?
Security tokens are financial securities that have to be compliant with existing rules and regulations within their respective industries (supervised by financial regulators). They can provide an array of financial rights to the investor such as profit share rights, voting rights, buy-back rights and more.
Many existing centralized launch platforms don’t do Security Token Offerings (STO), due to the challenges of dealing with security (which are not the same as exchanges for currencies or utility tokens).
In order to offer security tokens, the company must have a license (for example, a security dealer license or a bank license). Depending on the jurisdiction in which the company is located, it can be difficult to obtain this license.
Also, since security tokens come with many regulations and limitations on who can invest in them, they cannot be traded freely. This means that they are subject to many secondary trading restrictions (clean and thorough on-boarding process AML/KYC).
Why is the UI/UX of a decentralized Exchange hard to make user-friendly?
Decentralized exchanges remain poorly understood and one of the main setbacks for beginners who are trying to break into it is the difficulty of operating cryptocurrency exchanges. Even users who are computer literate and have experience with online financial technology find learning how to use crypto wallets and ledgers quite challenging.
Why is it so difficult to use decentralized exchanges?
- There’s a lot of jargon that the user must learn, so at first it can almost feel like they are struggling to understand a foreign language.
- There is also a lot of technical information that every user must know, which is different for each individual coin / token. (Which means that the learning curve is initially incredibly steep).
- A user needs to figure out how to set up their digital wallet and how to securely store their private keys and passwords — as these are essential to the account.
- The process of converting fiat currency into cryptocurrency is complicated and it’s challenging to break it down into a simple way that can be displayed on a user-friendly interface.
- It’s hard to use cryptocurrency to make real life purchases in most big marketplaces. There are only a limited number of (useable and valuable) consumer application (DApps) on the market.
- Moving coins from wallet to wallet with long and obscure addresses is very difficult — even for seasoned traders there is the risk of losing all of your money during the transfer by entering one wrong character in the address.
- Also, the confusing interface of many exchanges means that it’s easy to make mistakes when buying and selling — for example accidentally selling 100 Bitcoin for 10 cents.
- Cryptocurrency is very abstract. Many people find it easier to understand physical objects having value, rather than the notional value and artificial scarcity of cryptocurrency and / or tokens.
What does true decentralization mean?
Decentralization is one of the main ideas behind blockchain. For example the Ethereum Blockchain currently has around 12’000 nodes — this means that it is the most decentralized public Blockchain. Blockchain without decentralized proof, whether based on PoW (proof of work) or PoS (proof of stake) is nothing less than a centrally controlled, private, non-tamper-resistant database. Such databases already exist for long time before the introduction of Bitcoin.
In a very general sense, decentralization means that no single entity has exclusive control over the data or the processes. Whenever a change is made to the transaction record, it must be confirmed by the vast majority of blockchain users in order to be considered legitimate.
However, just because the transaction records are decentralized doesn’t mean that a blockchain is decentralized in all respects. For example, take a look at ownership. In most cases, it is a centralized company that completely owns the platform blockchain company.
Also, just because a blockchain operates in a decentralized way — it doesn’t necessarily guarantee the privacy of its users. For example, Bitcoin transactions can be traced and are not necessarily private.
One of the most interesting yet challenging concepts in the world of Blockchain is a DAO — a Decentralized Autonomous Organization. It is an organizational scheme that is designed to work without too much tinkering, while being as transparent as possible. Theoretically, a DAO can run itself without being bogged down in bureaucracy. Ideally, it will adhere to principles of inclusivity, transparency, collaboration, adaptability and community.
Recently (September 2018) Mr. Vitalik Buterin, Ms. Zoë Hitzig and Mr. E. Glen Weyl released their paper Liberal Radicalism: Formal Rules for a Society Neutral among Communities. In our opinion a decentralized exchange should be a public good, as outlined in the above linked essay. A decentralised, self organising ecosystem sounds very much like the concept of the DAO. The difference here is presumably going to be in the details of how they intend to achieve near optimal provision of public goods out of this organisation, which is something the DAO didn’t cover (more information). In a soon to be released update we will go into detail on how we think this can be achieved.
We are building an exciting decentralized exchange & launch platform solution in the heart of Crypto Valley (Zug) as we speak! Are you curious? Want to learn more about it? Contact us today!