Back in 2019, a valued 99% of crypto-asset transfers took place on centralized exchanges (CEX), according to the number used by senior crypto critic Nouriel Roubini. CEXs will likely remain a central part of the crypto trading landscape for the foreseeable future. CEXs are quick and convenient, but generally require traders to deposit funds into an account controlled by the exchange. Unfortunately, history shows that this loss of sovereignty over a user’s digital assets can be an extreme and costly compromise.
Decentralized Exchanges (DEX) offer an interesting alternative and are gaining ground, but are not yet ready for prime time. Therefore, there must be a way to bridge the gap between user sovereignty and exchange performance.
Related: DeFi demonstrated resilience during the market crises of March 2020 and May 2021
When it comes to custody, control is better than trust
The nightmare scenario for traders using CEXs is that they could fall victim to hack or fraud and lose their deposited funds. Although seven years have passed since the collapse of Mt. Gox in 2014, his name is still synonymous with the dangers of cryptocurrency fraud. Once the world’s largest Bitcoin exchange (BTC), it filed for bankruptcy in 2014 after Bitcoin’s demise of around 650,000 customers. Victims are still trying to receive partial compensation from the insolvency proceedings in 2021.
Unfortunately, this form of counterparty risk remains a threat to this day. In April, the founder of Turkish exchange Thodex fled with $ 2 billion in assets from untraceable investors. A year ago, the Chinese FCoin and the Australian ACX closed without warning. Whether these failures are due to fraud, hacking, or issues with the business model, it doesn’t matter much to investors left behind. In an ideal world, the exchange trader (or a hacker who has compromised an exchange) should be denied the ability to move client funds on a discretionary basis between accounts.
Related: Trust is Still a Must in the Untrustworthy World of Cryptocurrency
The status quo: managing risk leads to higher costs
For well-capitalized or well-connected traders, there are ways to mitigate these risks, but the solutions have their own drawbacks.
Credit is one way to avoid having to pre-finance an account. Yes, it is possible if you are willing to pay high fees to a broker or if you can get a line of credit from a particular exchange by establishing yourself as a top client. Either way, it’s expensive (and in the latter case, slow), and only the biggest spenders have a chance to develop such a great relationship with multiple exchanges.
OTC settlement networks offer an alternative to loading funds directly to exchanges. These intermediaries hold the trader’s funds and assume the counterparty risk for each exchange. In today’s environment, these intermediaries provide a valuable service to institutions, but they still represent an additional layer of expense. So much for frictionless trading.
DeFi and the problem of transparency
If the problem is the loss of sovereignty of assets over CEXs, could DEXs be the solution? Yes and no. By using smart contracts and decentralized liquidity pools to enable asset trading, DEXs do away with middlemen and allow traders to retain sovereignty over their assets. However, DEXs also come with heavy tradeoffs, especially for large traders.
On a DEX, instead of buyers and sellers being matched through a centralized match engine, a smart contract performs the transactions. Participants called “yield producers” can lock their assets into a cash pool and earn returns in return. Each liquidity pool makes it easier to trade a particular asset pair, like Bitcoin and Tether (USDT), for example. The smart contract will adjust the returns based on the relative volume of assets in the pool, in order to attract more of the rarer assets and maintain a healthy balance. At the same time, the transaction fees paid by a trader will vary depending on the relative scarcity of the assets involved.
Although innovative, this approach does not adapt well. Depending on the size of the liquidity pool, large transactions can immediately have a large effect on trading costs. In addition, DEXs are very sensitive to frontrunning. Pioneers are traders (often bots) who look for information suggesting that a big trade is coming, then go into their own trade to take advantage of the expected price movement. Of course, these abusive trades have their own effect on the market price, reducing the profit of the originally planned transaction. On CEXs, the risk is that if the pre-financing is done on-chain, third parties may be able to infer that a big deal is about to happen. However, these risks are greatly magnified when using a DEX.
Due to the networking delay during transaction processing, pending transactions can flow among commit nodes before they are finally committed in a block. This is because on smart contract-based DEXs, bids are sent transparently, so a favorite just has to observe the incoming bids and place their own bid with higher fees or with less delay in placing. network to profit from it. Additionally, as validators decide the order of transactions for the blocks they produce, this could introduce another opportunity for manipulation.
So while DEXs are a tempting idea and offer the opportunity to earn passive return, they are currently not well suited to the needs of most traders.
Related: Yield farming is a fad, but DeFi promises to change the way we interact with money
Can we create a better DEX?
So, can the interests of traders be better protected without the drawbacks of existing DEXs?
One possible approach here would be to use blockchain as a source of trust and combine it with confidential off-chain hardware to handle order matching. For example, Trusted Execution Environments (TEEs) can establish an isolated area within a computer processor, running separately from the standard operating system that is not accessible to the system administrator.
The matching engine and trade execution software for an exchange could be placed in a TEE, removing it from the control of the exchange owner. Each trader could then determine an allowance that the TEE could spend to settle transactions on their behalf, eliminating the need for pre-financing or middlemen. In addition, since the pairing would be done off-chain, the risk of frontrunning would also be reduced.
Thinking longer term, a combination of other emerging techniques such as multiparty computation or zero-knowledge proofs could be used to achieve similar results, but these approaches are currently less mature and would be difficult to implement in applications. real world scenarios. .
Conclusion
The need for pre-financing on cryptocurrency exchanges introduces issues and risks that are a significant barrier to the adoption of digital assets. While DEXs offer an innovative alternative that leaves the trader in control of their funds, they also involve significant tradeoffs. To drive widespread adoption of digital assets and gain competitive advantage, cryptocurrency exchanges need to explore ways to preserve user sovereignty without compromising performance.
This article does not contain any investment advice or recommendations. Every investment and trading move comes with risk, and readers should do their own research before making a decision.
The views, thoughts and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Alain Brenzikofer is co-founder of Intenitee AG, a confidential hardware-based IT solution that combines blockchain and trusted execution environments. Active in the blockchain since 2013, he contributed to the Quartierstrom peer-to-peer energy markets initiative and founded Encointer, a crypto-based universal basic income project. In 2020, he led the team that won the Energy Web Innovation Challenge for a project that used reliable runtime environments for off-chain computing.
