Crypto currencies are decentralized products traded largely on centralized exchanges. Cryptocurrency proponents note that an advantage of cryptocurrencies like bitcoin and litecoin is that reliance on or trust in a third party is not required to transact. Centralized exchanges, however, themselves may make it hard to open an account or may place restrictions or ban the withdrawing of funds or cryptos. Centralized exchanges can also be be hacked or closed by governments. Thus, centralized exchanges may run counter to one of the advantages of transacting in cryptocurrencies.
Centralized exchanges provide places for price discovery to take place. On a centralized exchange the operator of the exchange buy and sells its crypto inventory on behalf of its users. The potential for abuse exists, especially absent regulation. A centralized crypto exchange can operate a fractional reserve system of trading and credit user accounts with crypto currencies that may or may not exist at the exchange. The exchange may rely on the knowledge that many account holders may not withdraw their crypto currencies. The possibility of this type of practice most likely was one of the reasons for China’s decision to close crypto exchanges.
Regulated centralized exchanges, however, hold promise as a way of integrating the entire crypto currency space with the existing financial system. In “Crypto Currencies Fiat Strenghteners or Killers?” we noted that solutions like tenx and others that allow for a variety of crypto currencies to be brought onto Visa cards so that they may be spent worldwide.
Fidelity Investments recently provided its nearly 70 million customers with an integration option whereby they could access their coinbase accounts on their Fidelity dashboards. Coinbase accounts as of this writing were at 10.5 million. If crypto currencies are to become fiat strengtheners, heavily regulated exchanges are necessary to track transactions and collect taxes.
Enter Decentralized Exchanges
Decentralized exchanges don’t require users to provide indenitfying information and their servers reside in different locations. A decentralized exchange holds no assets or customers funds and therefore there is nothing to sieze or central location to shut down. Using a decentrazlized exchange users can buy and sell crypto currencies with other users on the platform or off platform in person. Decentralized exchanges make it extremely difficult to track transactions and collect taxes.
Currently, the volume of crypto currency trading on centralized exchanges is vastly greater than volumes trading on decentralized exchanges. With the closing of the Chinese cryptocurrency exchanges, however, decentralized exchanges have seen an increase in trading volumes.
The number of decentralized exchanges are proliferating. Here are just a few of them:
Priced in Fiat or Bitcoin?
Crypto detractors say that Bitcoin and other cryptocurrencies derive their value from the ability to convert into fiat currency to purchase goods and services. Some go as far as to say that this makes cryptos themselves an extention of debt based fiat currencies. If cryptos inevitably become fiat strengtheners with full integration into the banking system, that point of view has validity.
If however, governments crack down on crypto currencies and don’t embrace centralized crypto currency trading, increased trading may occur on decentralized exchanges and the crypto ecosystem may instead of pricing cryptocurrencies and tokens in fiat pairs, price them only in Bitcoin or Ether.
Atomic swaps allow users to by-pass even decentralized exchanges and transact with each other, even if the transaction involves different cryptocurrencies. Atomic cross-chain trading allows users to trade cryptocurrencies on different blockchains. For example atomic swappers holding alt coins like Litecoin can trade with holders of Bitcoin (or vice versa) at an agreed ratio (currently about 75-1; just like the gold silver ratio). Atomic swaps can occur using digital signatures that act as a functioning escrow that prevent one party from sending coins to anther party and not receiving the bargained for swapped coins in return.
Developers are currently testing atomic swaps. Charlie Lee, creator of Litecoin, recently tweeted his success in an atomic swap involving Bitcoin and Litecoin.