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As often as members in the crypto-community tout “decentralization,” there is still one truth: centralized cryptocurrency exchanges are kingmakers in this ecosystem.
Centralized crypto-exchanges hold tremendous power, choosing to be the picks and shovels in a space where everyone is looking for gold (or fools gold). And with this choice, they are generously rewarded. Recent estimates show that centralized crypto-exchanges generate millions of dollars in revenue through exchange trading fees. Furthermore, these exchanges often change ICO project listing fees that can reach $1M per token.
Unsurprisingly, the control of these exchanges has stimulated the development of decentralized alternatives in the form of decentralized exchanges (DEX). In fact, there are close to 250 projects attempting to build DEXs.
Where are the points of entry for DEXs?
To understand the rise in the development of DEXs we must examine the core issues with centralized exchanges.
- Central points of failure: One of the most serious issues with centralized exchanges is custody risk. When investors trade on centralized exchanges, they give over full control of their funds. The accumulation of funds on centralized exchanges turn them into honeypots for hackers. Just this year, one of the largest cryptocurrency exchange hacks led to investors losing $533M. In 2018 alone, investors lost over $800M to cryptocurrency exchange hacks. When investors use centralized exchanges, they have to trust a third party to secure and protect their funds.
- Censorship: Centralized exchanges can censor their users. That comes in various forms: preventing users from withdrawing or depositing funds or directly banning them for using the platform. Additionally, because centralized exchanges are inherently easier to target, governments can ban exchanges from operating in their country — as shown by China’s 2017 exchange ban.
- High Fees: As we’ve mentioned prior, because of the power imbalance between exchanges and users/projects, centralized exchange often leverages their power to charge obscene fees. Trading fees on some exchanges can go as high as 1.49% (Coinbase) while listing fees can reach as high as $2.6M (Binance).
- KYC: Many major countries require financial institutions (cryptocurrency exchanges included) to follow Know Your Customer (KYC) rules for verifying their users. For exchange users, these rules are a no-go for privacy-conscious investors. Furthermore, KYC rules also prevent some 1.1N people — mostly in developing countries — that do not have official identity documents from accessing exchanges.
With the problems facing centralized exchanges, how do DEXs solve them?
- Central points of failure → Decentralized network: Unlike centralized exchanges where a single party manages trades, DEXs facilitate trades through peer-to-peer networks. And because DEXs run on a decentralized network of servers, there are no single points of attacks from hackers.
- Censorship → Uncensorable: Unlike centralized exchanges where private keys are managed by the exchanges, on DEXs users have full control over their private keys and how their funds are used, secured, and transferred. DEXs, by their very nature, can prevent users from accessing their platform. Moreover, because no single entity has control over DEXs, DEXs cannot be pressured by regulators and governments to shut down or censor specific trades.
- High Fees → Lower fees¹: Because they typically lack large operation cost (hiring customer service agents, lawyers, C-suite executives, etc.) DEXs often charge negligible fees or in some cases offer fee-less trades. Trades on DEXs often happen through smart contract executions, and traders only pay transaction fees for miners of a blockchain.
- KYC → No KYC: Because DEXs are not single entities it is difficult for regulators to require KYC verification processes. As such, currently, DEXs do not require users to go through a KYC verification process to begin trading.
What are the barriers to entry?
While many entrepreneurs are building DEXs, early stats show that is still a lack of activity on these exchanges. According to DappRadar, over a span of 24 hours, the top 5 DEXs on Ethereum processed ~6,877.54ETH in volume — roughly $1.9M. In comparison, the 24-hour trading volume of centralized exchanges is over $2.9B. In other words, the top five DEX’s have 0.0641% the trading volume that the top five centralized exchanges have.
There can be a number of reasons for this lack of use:
- Functionality: Compared to centralized exchanges, DEXs have limited features. For example, DEXs rarely have different order types (stop losses, limit orders, etc.). Additionally, the user-experience of DEXs are often unfriendly for the average user.
- Speed: By their very nature blockchains are slow databases. This leads to slow trades (transactions) on DEXs as all transactions have to be processed by miners on the blockchain.
- Lack of liquidity: Exchanges are marketplaces, and marketplaces need network effects to operate. Because DEXs are relatively new to the cryptocurrency exchange space they fall into the chicken and egg problem — traders join highly liquid exchanges but for exchanges to be liquid they need traders to join.
While, like many projects in the crypto-space, it is too early to judge the success of DEXs, Coinbase’s acquisition of Paradex and Binance’s development of a DEX show that there is increasing interest in this sector.
*¹ Fees are complex as they typically depend on the structure of DEXs. For example, users of the 0x protocol can, in theory, make free trades but often pay Relayers for the convenience of speedy trade executions. Additionally, miner fees can fluctuate greatly depending on the traffic on a blockchain.