The Link Between Money, Exchanges, And Cryptocurrencies
By Sidra on ALTCOIN MAGAZINE
Money has no innate value; it is a concept that begins and ends with people. We use money every day in all its different forms, be it cash, plastic or digital. Whenever a person has money in their pocket, they value it in terms of what they can buy with it. What gives money its value is to be universally accepted as a medium of exchange.
Introduction to Crypto Exchanges
Cryptocurrencies are blockchain digital asset. It is based on the principle that “its value can’t be copied”. Recognition of cryptocurrencies is bringing disruption to banking and financial systems the same way the internet brought to the newspaper industry and publishing agencies.
The concept of digital currencies dates back to the 1980s. After the financial crisis, 2007–2008 the concern with digital money arose that it could be copied easily without a way to ensure its authenticity. In the year 2009, Satoshi found a way to make digital money scarce by using cryptographic principles. He made the first-ever application Bitcoin based on blockchain technology with a consensus mechanism proving the validity of transactions.
Bitcoin is the first cryptocurrency and a decentralized application. To build an application on top of bitcoin. Because of its limited scripting language developers need to have a deep understanding of cryptography, mathematics, and programming to be able to build decentralized applications. Ethereum platform was created to solve this problem allowing developers to deploy decentralized applications.
Problem with Cryptocurrencies
Cryptocurrencies have proven a way to program money with scarcity. They need to be exchanged in a matter of seconds to be used as money. However, cryptocurrencies like Ethereum and Bitcoin lack the property of scalability, meaning they cannot handle transactions at high throughput and they cannot work with microtransactions (taking into account the mining fee and the gas fee involved). In the current scenario bitcoin processes, about 7 transactions per second whereas, ethereum can handle 15 transactions per second. This is very low as compare to what Visa can handle 24,000 transactions per second.
Crypto Exchanges
If cryptocurrencies are to be used as regular money, they should be treated as such money not investment opportunities. Money has value only if it is capable of being exchanged for commodities just like a dollar bill is. Crypto Exchanges are global marketplaces to trade cryptocurrencies with fiat money or other cryptocurrencies.
There are over 1600 cryptocurrencies available on the internet that you can buy. Consider cryptocurrencies as foreign currencies that need to be exchanged with each other to be used in certain states. In the real world, you go to a bank and you exchange your euro to dollars and vice versa. In the crypto world, you need to go to an exchange where you place an order to exchange bitcoin with ether or buy some bitcoin for fiat currency.
The dilemma here is the centralization inside of a decentralized system. To go through the buying and selling of cryptocurrencies, you have to go through certain exchanges that help you find a buyer or a seller. The reason why blockchain is revolutionary is that the concept of a middle man has been removed. Centralized exchanges kill this very idea of decentralization that needs no intermediaries, which is a cause of concern for crypto enthusiasts.
The reason centralized exchanges are so successful is that people are not familiar with the technology and they want an easy way to get hold of cryptocurrencies resulting in the boom of centralized exchanges. There are several centralized exchanges out there, some of them are Bithumb, Bitfinex, Bittrex, Poloniex, Kraken, GDAX, Coinbase and Gemini.
The Drawback of Centralized Exchanges
Centralized exchange (CEX) model works on IOU principle, which means every transaction that is being carried out is just a numeric representation. There is no transaction taking place on the chain.
Centralized exchanges keep your private keys inside their servers which are prone to get hacked, resulting in the theft of private keys. Once a hacker has access to user private keys he can take control of user wallet and transfer all the amount to his wallet without anyone knowing. Centralized exchanges take their share on every transaction, earning a lot of money in the process. Centralized exchanges are now regulated by governments that limit the exchange and jeopardize the concept of decentralization of money, taking the control away from the user.
Among other problems with centralized exchanges is front-running where exchange administrator can take advantage of arbitrages. Despite the popularity, they are not able to scale well with the increase in the number of users either.
Centralized exchanges can take down any coin/token at any point in time. It costs a lot of money for a token to get mentioned. However, a dapp in its infant state needs instant liquidity and a market for its tokens to attract investors.
Following are the Problem Caused by CEX to the Users in a Nutshell:
- The closing of new signups for users.
- Implementing withdrawal limits.
- Delisting of coins without warning.
- Front Running and Manipulation.
- Profits and Fees.
Solution
- Build a decentralized exchange(peer-to-peer marketplaces of varying degrees using smart-contracts).
- Let users retain control of their funds
Concept of Dex
Many people understand the risk of trading on centralized exchanges and they are seeking a way out. These reasons have led to decentralized exchanges. Decentralized exchanges (DEX) are peer to peer marketplaces for the people and made by the people, eliminating central points of failure. They operate on a single distributed ledger just the way cryptocurrencies leverage blockchain technology to give back users the control of their funds. This means that they don’t store people’s information or private keys, operating only on the transaction history.
Problems Faced by DEXs are:
- Not user-friendly and require more clicks creating problems for naive traders.
- They have limited functionality and they lack liquidity.
- Dependency on the underlying protocol in terms of speed, cost, and range of tokens.
- Transactional inefficiencies hosting order book on the blockchain is slow and blots the blockchain.
Types of Decentralized exchanges
You can classify decentralized exchanges into three types:
- On-chain exchange (exchange logic embedded in a smart contract).
- Hybrid Dex (off-chain order book on-chain settlement).
- Automated market makers e.g Bancor protocol.
Currently, there are many decentralized exchanges available. Every exchange has implemented its logic to solve challenges of trust and liquidity. To provide exchange functionality for ERC20 tokens, exchanges are using protocols such as 0x, Bancor, {set}’s, all making use of atomic swaps to provide cross-chain functionality.
0x protocol
Order book maintained by relayers. Relayers order book maintains orders signed by taker private key. Relayers are incentivized with fees to do the expensive operation of order book maintenance. Relayers are connected via exposed API resulting in a network of liquidity pools.
Bancor
Based on a smart contract, Bancor provides an automated price dependent on reserves available in the network using what they call a fair mathematical formula.
EtherDelta
Provides exchange functionality of ERC20 tokens making use of smart contracts to execute trades while maintaining an off-chain order book. The problem is that there is only one order book which can get hacked. However, there is no way for a hacker to get the user funds but the network loses its liquidity. It still ensures better security of funds than centralized exchanges.
Sets
A set token is a collateralized basket of ERC20 tokens representing an abstraction of underlying ERC20 tokens. It consists of a smart contract designed to be the superset of ERC20 tokens with the issue and redeem functionality.
Kyber Network
It provides an instant swap service. Provides exchange functionality for ERC20 based tokens. They make use of public/private reserves for liquidity. Reserve manager decides who can and cannot be a reserve provider and the user only interacts with the Khyber contract that acts on their behalf.
Raiden
On-chain smart contract based exchange that handles financial transactions and web application. There is no fee charged by the exchange and the only fee users have to pay is the mining fee. It is the first exchange for ERC-223 tokens.
Blocknet
Enables inter blockchain exchange of value by using cross-chain swaps based on atomic swaps.
NEM exchange
Maintains an off-chain matching engine for both buyer and seller interact with the trading engine. Whenever orders get matched, the trade is executed on the blockchain. They are currently providing exchange functionality only for ether and NEM.
Conclusion
Cryptocurrencies can play an important role in financial inclusion. Poor people can get access to financial services they have been longing for. Centralized exchanges make financial inclusion difficult. They require down payments before you can make any actual transaction on the exchange, KYC process and transfer limit.
However, DEX doesn’t require KYC, provides liquidity, high-performance trading. User can be anonymous and transfer an unlimited amount of money in less time. They have their downsides bad UI/UX results in bad user experience.
Both Dex and CEX will work together in the future. There is market demand for both DEX and CEX. With future work and research involving scalability, atomic swaps and lightning network will result in the success of Dex.
