Centralized exchanges and decentralized trading platforms may on the surface appear much the same, but scratch that surface and clear differences emerge. These two trading platform templates differ in many ways, but the one key point of difference is that the future lies with decentralized exchanges. The latter’s star is on the ascendent and will, in 2021 and the years to come, be the prevailing form of exchange.
Centralized exchanges help users exchange value, but they don’t give those users control of the private key associated with their exchange wallets — the exchange keeps control of their wallets. With a decentralized exchange (DEX), funds can be traded directly by an individual from their own wallet, without having to go through a deposit process — the user is in control.
For a cryptocurrency user, the Golden Rule is: “not your keys, not your coins.” For centralized exchanges, therein lies their biggest problem. Exchange users don’t have control of their funds — they have to rely on third-party providers. Having to trust a third-party with one’s finances or personal information is the biggest drawback of these centralized platforms.
Decentralized exchanges fare better in this context. They provide a better solution and are duly gaining traction in the cryptocurrency space. Yet, despite their upward trajectory, DEXes are held back by a number of obstacles and issues, notably on the regulatory side. These still need to be addressed.
Yet, on the regulatory front, there are changes on the horizon. After all, there’s widespread recognition that it’s an industry in need of greater scrutiny in order to earn the confidence of investors required to reach the next level of adoption.
Decentralized exchanges aren’t perfect
Industry watchers have witnessed the rise of U.S.-based Uniswap (UNI), which is now the sector’s leading DEX — one that continues to grow. As of publication time, it currently exceeds US$2.2 billion in total value locked, a figure that represents how much liquidity users contribute to the different trading pairs. As well, Uniswap has averaged about 4 million active trades each month for the past few months, according to Dune Analytics. The overall DEX metrics dashboard confirms Uniswap represents over half of all DEX trading volume today.
Uniswap is an Ethereum-based exchange that addresses the liquidity problem faced by many DEXes, by using an equation that automatically sets a value for ERC20 tokens. The value depends on the level of demand but does not actually require buyers or sellers.
Numerous projects have tried to mimic this model and failed. SushiSwap, once widely considered a better version of Uniswap, saw its initial popularity fall due to actions by the initial developer. The developer took $14 million from the SUSHI development fund and claimed it as his own. The money was later returned.
See related article: Congested Ethereum hosts 96% of DeFi transactions. Who are its up-and-coming competitors?
At their core, DEXes are not controlled by an individual or a group. Instead, they are built by using smart contracts that operate on the blockchain. These contracts are controlled by the person or group responsible for creating them.
However, one outcome of having this structure is that DEX users don’t have full control over how a specific platform can grow or evolve. That can have its drawbacks.
Issue #1: The single-token approach
Some DEXes have introduced their own native tokens. Uniswap, for example, launched its UNI token on September 16, 2020. At least 400 tokens were offered free of charge to anyone who had used the exchange. Airdrops, which represent a distribution of new tokens at no monetary cost, are not uncommon in the industry, but they typically do not benefit the long-term value of an asset. Uniswap’s UNI token has, despite a strong start, lost 54% in value from its all-time high two days after its launch.
Native tokens become more problematic when competing DEXes are involved. While the underlying objective is to create liquidity — without actually having to make a trade — by making them earn platform-native tokens, these are also governance tokens. Contributing a speculative value to a governance token by making it a tradeable asset on exchanges, rather than have it serve merely as a utility token with no monetary or speculative value, is a topic of debate in the community.
One way to avoid such a problem is to separate governance tokens and utility tokens offered by DEX platforms. This would make governance tokens more useful, rather than speculative.
Genuine governance tokens should not be subject to the speculative whims of cryptocurrency enthusiasts. The only purpose of governance tokens should be to let interested parties cast their vote on proposals, changes and improvements.
Issue #2: Lack of cross-chain support
Another problem plaguing the DEX industry is the lack of cross-chain support. It means, for example, that a platform such as Uniswap only works for Ethereum enthusiasts. It does not support any of the other blockchains, such as EOS, Tron or even Bitcoin.
Yet, an ability to tap into cross-chain liquidity and create completely new markets is something the industry needs today more than ever. Uniswap developers are working on a new version of their platform, but from the information made public so far, there is no sign of cross-chain support being part of it.
Unfortunately, this issue is a real challenge. It is difficult to make blockchains communicate with one another if there is no support at the protocol level. There is no widely used standard for enabling this level of communication either.
On the bright side, however, there are some projects currently building cross-chain solutions that have real promise. One example is Singapore-based Switcheo, which recently secured US$1.2 million in additional funding. Switcheo’s implementation allows traders to move liquidity between supported blockchains while retaining control over their funds and private keys.
Intriguingly MXC, a centralized exchange based in the Seychelles, contributed in this funding round. According to MXC Investment Director Amos Sun, derivatives will become a crucial part of decentralized finance (DeFi), and Switcheo will become the main provider in this segment. MXC continues to put a strong focus on building its one-stop DeFi mining service, as well as advancing the DeFi industry as a whole.
Cybersecurity issues remain
One looming concern comes in the form of cybersecurity. Decentralized platforms have a reputation for being vulnerable to hackers and other security breaches. There have been numerous instances of this since the emergence of crypto currencies and exchanges a decade ago.
In mid-October, OKEx, a Chinese exchange registered in Malta, suspended cryptocurrency withdrawals for several weeks — they resumed on November 26, 2020. It followed news that owner Star Xu was taken into police custody in China. The suspension denied users access to their funds or from receiving funds in their own wallets. Although OKEx, one of the world’s largest exchanges, is operational again and offered rewards to users for inconvenience caused, trust was clearly dented.
Given the growth of digital exchanges and greater investor participation, regulatory scrutiny is inevitable. In Hong Kong, for example, the Securities and Futures Commission now requires all exchanges to be fully regulated. It’s a positive development for the industry, as regulation provides better investor protection, more accountability and, of course, more legitimacy.