Among cryptocurrency’s most prized attributes is the high level of security facilitated by the blockchain when conducting transactions. Through the use of cryptography, a decentralized network can ensure that the ledger upon which all transactions are recorded is effectively tamperproof.
And yet we’re constantly hearing stories of hackers making off with millions of dollars’ worth of crypto at a time. How is this possible, given blockchain’s fortress-like qualities? Well to date, the responsibility for this failure has mostly lay with crypto exchanges.
Indeed, it already seems anachronistic that despite all the talk of security when it comes to crypto and blockchain, exchanges continue to represent a distinct weak link in this space. Well, centralized exchanges do, that is…
Bittrex, Binance, Poloniex and hundreds more exchanges play a crucial role in the crypto world. Between them, they provide venues to purchase virtually every token on the market. They also generate much-needed market liquidity by matching buyers and sellers, they offer stable trading platforms for crypto investors to make money, and they are relatively easy to use.
But it’s also no secret that centralized exchanges are also prime targets for cyberhackers – from the $473 million hack of Mt. Gox which led to its eventual bankruptcy, to the $72 million Bitcoin theft from Bitfinex in August 2016, and most recently to the biggest heist of all – January’s $530 million hack of Japanese exchange Coincheck. Many of the biggest thefts of all time have taken place on centralized cryptocurrency exchanges.
The problems with centralized exchanges
The moment you put your crypto on a centralized exchange, you no longer control it. Even if it is stored in your exchange wallet, the exchange itself remains in control of your holdings, as well as your wallet’s private keys, until you withdraw and send the coins elsewhere (to a personal wallet, for example).
That’s clearly disconcerting to say the least. And to compound matters, the exchange holds all customer funds in just a few addresses. Known as ‘honey pots’, these addresses become prime targets for hackers.
As a Reuters investigation last year found, many cryptocurrency exchanges are “plagued with poor security and lack investor protections common in more regulated financial markets”. Although the SEC recently asserted that exchanges should seek appropriate registration with regulators on the back of such security concerns, it doesn’t seem as though the rate of successful hacks will decelerate any time soon.
And speaking of regulation, given that centralized exchanges are centrally domiciled businesses, this subjects them to the rules of the country in which they are based. So, if the exchange has been operating in China, for instance, the chances are that its very existence as been severely threatened by the country’s crackdown on cryptocurrencies and ICOs that began in earnest last September.
Furthermore, the trading fees that are taken by centralized exchanges can be hefty and are not necessarily transparent in how they are calculated. Such fees are indicative of the costs centralized exchanges have to bear, such as the costs of maintaining the infrastructure required to securely manage user funds.
With such concerns in mind, the need for an alternative system of exchange has become a priority for crypto users, authorities, and in many cases, the exchanges themselves.
Enter decentralized exchanges
A decentralized exchange (DEX) primarily differs from a centralized exchange by not having a centralized third party to take custody of user funds or to settle trades and disputes. Instead, DEXs enable peer-to-peer transactions on a blockchain, which in turn means that users can retain control of their crypto and private keys at all times.
DEXs are governed openly by their users, as opposed to one single authority, which allows them to operate in a trustless and significantly more secure environment than their centralized siblings. With funds not being kept in one centralized place, the likelihood of large-scale hacks is therefore greatly reduced.
To date, most DEXs have been built on the Ethereum blockchain, and are therefore able to support the exchange of ETH and ERC-20 tokens. Using smart contracts, transactions between network peers are executed using the private keys of the participants.
Thus far, the process to trade on existing DEXs has been fairly similar across the board:
Popular decentralized exchanges
Many more DEXs exist, and can be identified on a comprehensive list that is being updated on GitHub, along with their respective protocols.
Advantages of using decentralized exchanges
Such benefits could ultimately mean that DEXs become the preferred venue for trading digital assets, especially if there is no end in sight to the cyber-attacks being carried out on centralized exchanges.
At this stage, however, DEXs have their own challenges to overcome. In our next piece on this topic, we outline a few of those challenges, and some of the potential solutions currently being proposed.
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Dr. Justin S P Chan has a passion for clarity and synergy - seeing through the complexity of the intersecting spheres of technology, finance, innovation and social dynamics, to enable game-changing collaborations between entrepreneurs and innovative opportunities. Combining the vision of a true inventor and entrepreneur with his data-driven, evidence-based approach to investment, Justin also co-founded OCIM and serves as Chief Investment Officer for its fund management platform. Within OCIM, He co-manages OC Horizon Fintech, a transformational hedge fund, where he blends real applications, expertise and future-awareness into truly exceptional investment performance. Justin gains inspiration for these projects from his global network of contacts in investment and fintech communities, where he stays on the pulse of fast-moving conversations and trends affecting global markets and emerging technologies.
John DeCleene is a fund manager for OCIM’s fintech fund, and currently progressing towards becoming a CFA charter holder. He loves to travel for business and pleasure, having visited 38 countries (including North Korea); he represents the new breed of global citizen for the 21st century. Whilst having spent a lot of his life in Asia, John DeCleene has lived and studied all over the world - including spells in Hong Kong, Mexico, The U.S. and China. He graduated with a BA in Political Science from Tulane University in 2016.
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