In 2019, according to figures from the great crypto critic Nouriel Roubini, an estimated 99% of transfers of crypto assets took place on centralized exchanges (CEXs). CEX is likely to remain a central part of the crypto trading scene for the foreseeable future. CEX is quick and convenient, but often requires traders to deposit funds into an exchange-controlled account. Unfortunately, history has shown that losing sovereignty over users’ digital assets can be an extreme and costly tradeoff.

Decentralized exchanges (DEXs) offer an attractive alternative and are gaining momentum, but are not yet ready for the big time. So there has to be a way to bridge the gap between user sovereignty and stock market performance.

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When it comes to guardianship, control is better than trust

The nightmare scenario for traders using CEX is that they could be the victim of a hack or scam and lose their deposited funds. Although seven years have passed since Mt. Gox in 2014, his name is still synonymous with the dangers of cryptocurrency fraud. Once the world’s largest Bitcoin (BTC) exchange, it filed for bankruptcy in 2014 after the Bitcoins disappeared from around 650,000 customers. The victims are still trying to get some of the compensation from the 2021 failure.

Unfortunately, this form of counterparty risk remains a threat to this day. In April, the founder of the Turkish stock exchange Thodex ran away with $ 2 billion in unexplained investor assets. A year earlier, China’s FCoin and Australia’s ACX both closed without warning. Whether these failures are due to fraud, hacking or problems with the business model does not matter to investors out of their own pocket. In an ideal world, the exchange operator (or a hacker who breached the exchange) should be denied the ability to arbitrarily move customer funds between accounts.

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Status quo: risk management brings higher costs

There are ways for well-funded or well-connected traders to mitigate these risks, but the solutions have their own limitations.

A credit is one way to avoid having to pre-load an account. Yes, it can be done if you are willing to pay high fees for a broker or if, as a top customer, you can get a line of credit on a particular exchange. Either way, it’s expensive (and slow in the latter case), and only those who spend the most have a chance of building such good relationships with multiple exchanges.

Forex payment networks offer an alternative to making direct deposits on exchanges. These intermediaries hold the trader’s funds and bear the counterparty risk for each exchange. In the current environment, such intermediaries provide valuable services to companies, but still incur additional costs. So much for smooth trading.

DeFi and the problem with transparency

If the problem is losing ownership of assets on the CEX, can a DEX be the solution? Yes and no. By using smart contracts and decentralized pools of liquidity to enable asset swaps, DEXs eliminate middlemen and allow traders to maintain sovereignty over their assets. However, DEXs also involve heavy tradeoffs, especially for larger traders.

At a DEX, buyers and sellers are not paired via a central matching engine, but rather an intelligent contract carries out the transactions. Participants known as “productive farmers” can lock their assets in a liquidity pool and make profits in return. Each liquidity pool makes it easy to trade a specific pair of assets, such as Bitcoin and Tether (USDT). Smart contracts adjust returns based on the relative volume of assets in the pool to attract scarcer assets and maintain a healthy balance. At the same time, the transaction fees that traders pay vary based on the relative scarcity of the asset in question.

While this approach is innovative, it doesn’t scale well. Depending on the size of the liquidity pool, immediate large transactions can have a strong impact on transaction fees. DEX is also very prone to pre-run. The lead are traders (usually bots) looking for information that a big trade is imminent and then entering their own trades to take advantage of the expected price movement. Of course, these exploitative trades have their own influence on the market price and reduce the profit of the originally expected trade. With CEXs, there is a risk that third parties could infer an impending large transaction with on-chain pre-financing. However, these risks are greatly increased when using a DEX.

Due to network delays in processing transactions, pending transactions can go back and forth between validation nodes before they are finally committed to a block. In fact, smart contract-based DEXs send bids transparently, so the market leader can simply watch incoming bids and set their own bids with higher fees or less network latency to capitalize on. In addition, if validators set the transaction order for the blocks they generate, this can create another opportunity for manipulation.

While DEXs are a tempting idea and an opportunity to generate passive profits, they are not currently suitable for the needs of most traders.

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Can we build a better DEX?

So can the interests of traders be better protected without the disadvantages of existing DEXs?

One possible approach here is to use blockchain as a source of trust and combine it with confidential off-chain computer hardware to process the job matching. For example, a Trusted Execution Environment (TEE) can set up an isolated area of ​​a computer’s processor that runs separately from the standard operating system and cannot be accessed by a system administrator.

The matching engine and the trading software for an exchange can be localized in the TEE and take it out of the control of the exchange owner. Each merchant can then define an allowance that the TEE can spend on processing transactions on their behalf, eliminating the need for upfront payments or middlemen. Also, because the match is held out of the chain, the risk of a pre-run is reduced.

In the longer term, it is possible to use a combination of other emerging techniques such as multi-party computing or zero-knowledge evidence to achieve similar results, but these approaches are currently more incomplete and would be difficult to implement in real-world situations.

Conclusion

The need to raise funds in advance on cryptocurrency exchanges poses problems and risks that are a significant barrier to digital asset adoption. While DEXs offer an innovative alternative that puts traders in control of their funds, they also require significant tradeoffs. In order to drive mainstream digital asset adoption and gain a competitive advantage, crypto exchanges need to find ways to maintain user sovereignty without sacrificing performance.