Jun 1, 2017
By Liam Bussell
Historical Centralized Exchange Model (CEM)
The current paradigm of the CEM began with Mt. Gox, and has developed and matured to reach the status quo. The CEM allows companies to provide services for users to buy/sell tokens, or exchange them for other assets through a central gateway platform for a fee. These proceeds ensure the service provider in return offers customer support, security and a suite of product offerings. The strengths of the system have developed over time to coalesce around banking relationships (the ability to turn Bitcoin or ETH into cash) and providing liquidity. However, with repeated security breaches in various exchanges and poor management, public’s faith in the CEM system is increasingly waning. The fundamental question is one of trust — without an effective way to measure risk, users tend to under-price its potential.
However, there are deeper underlying issues other than security concerns and lack of trust. First among these is a lack of a mature infrastructure, and the system is skewed in its design as it rewards “early adopters”, be it an exchange, an information site or other service provider, making it difficult for interested new entrants to gain access to information which would allow them to objectively assess risk and engage in digital token trading reliably.
Secondly, and equally important, is the reputational issue . While much of the popularity of digital tokens are due to their decentralized nature, this fragmentation exacerbates many of the CEM’s inherent flaws, such as the lack of regulation and transparency, security risks, possible overcapitalization, and an opacity regarding creditworthiness and credit risk for token holders dealing with these exchanges. These shortcomings are major obstacles in the next development and widespread adoption of the digital token class as a whole.
In summary, centralized exchanges provide valuable services by acting as asset gateways. It allows the offering of multiple levels of market activities that cannot be matched by decentralized exchanges. However, these strengths are offset by a number of significant weaknesses, including the possibility of substantial financial loss, as well as the reputational damage to the digital tokens ecosystem. Each failure, be it Bitfinex or others, impact all users indirectly and reduced the valuation of the market as a whole, by damaging the credibility of digital tokens as a reliable medium of exchange.
The key weaknesses in CEM stem from:
1. Custody of customer digital tokens (private keys)
2. Corresponding credit risk to customers upon security or fraud incidents
3. Lack of consumer protection and avenues for dispute resolution
4. Lack of transparency on finances to allow customers to assess credit risk
5. Opaque closed source code and centralized data stores
5.1 Each develops their own exchange, deposit, withdrawal and security software; these are typically not open source (with no or limited audits)
5.2. Metrics and order data within centralised exchanges is not visible to customers, it is unclear to market participants if the reported data is true and complete
6. Fragmented liquidity as the proliferation of exchanges results in separate trading pools
If we look at the list of the most widely used exchanges, we find that the virtue of market dominance is driven by aggregation and accretion over time, the clear majority of trade volume is handled by a small number of player. Currently, most transactions run through approximately 20 centralised exchanges, with the bulk running through the top nine, namely:
• Poloniex • Kraken • Bitfinex • Quoine • BTC38 • BTC-e • Bittrex • Coinspot • Bitstamp
Out of these 9 exchanges, more than half have been hacked and suffered significant financial losses. The common assumption that the larger players should be more resistant to these malicious hacks due to having greater resources and better security has been disproven, as well as the idea that if an exchange keeps a low profile and attempts to tread a “middle path” it may avoid attracting the attention.
Emergence of the Decentralized Exchange Model (DEM) The shortcomings of centralized exchanges have seen a number of decentralized exchanges emerge. These largely fit into two categories; those that handle native fiat currencies, and those that handle only pure digital tokens.
A number of pure decentralized digital token exchanges and protocols are starting to emerge, notably on-blockchain markets such as cryptoderivatives.market, and offblockchain protocols such as 0x and Raiden for single blockchain token trading.
For cross blockchain exchange, the emergence of the Lightning network for cross blockchain atomic swaps is promising.
These initiatives are becoming broadly accepted by the industry as the likely future of pure native digital currency token trading. Each has benefits and disadvantages, but all lack fiat currency bridging, which is needed to avoid mainstream use of centralized exchanges. The closest fiat currency solution for these exchanges are modelled along the lines of Tether, where each tokenized unit of currency is reportedly held in custody. There is however some level of industry unease with regards to the transparency of data, and consumer protection with these types of solutions. Regardless of industry perception, there is clearly a degree of credit risk for customers of Tether style solutions, with entity, banking, and perhaps sovereign risks with little recourse.
The lack of convenient and safe fiat currency bridging almost certainly contributes to the lack of liquidity in pure digital token exchanges, in comparison to the incumbent centralized exchanges.
The other category of decentralized exchanges focus on the fiat currency problem. Various platforms such BitSquare have emerged which support fiat currency and digital token transactions; however, these exchanges have not managed to gain the critical levels of liquidity and trade volumes to supplant the centralised exchanges. The need to perform fiat settlements on a one to one basis to transactions is one reason for this. Highly liquid markets require the presence of market makers and arbitrage traders. These market participants require the ability to trade frequently, with a much higher frequency than that supported by trades linked to legacy financial services payment latencies.
The challenge then, is to solve the centralization problem while avoiding the pitfalls of existing, decentralized exchanges, such as low liquidity and a lack of choice when it comes to ancillary services.
https://www.youtube.com/watch?v=0sg7DsC6Ps4
For more details on the project, download the white paper at www.openanx.org
or join the slack channel
https://join.slack.com/openanx/shared_invite/MTg5MzA2ODcwMTE0LTE0OTYwNTEyMzItNDI5ZmU2NmFlNg
