Decentralized Exchanges Will Be The Future of Cryptocurrency Trading
Will All Cryptocurrency Exchanges Be Decentralized in the Future? It’s Possible
Decentralized exchanges currently compete with centralized exchanges for control of trading volume. In the future, however, decentralized exchanges could grow to dominate the industry.
Could decentralized exchanges be the way of the future?
According to a new report by Coindesk, the rise of decentralized exchanges could be inevitable. Today, 99% of trading takes place on centralized exchanges, but we could see this trend get reversed in the coming years.
We can break today’s cryptocurrency exchanges into three broad groups, including:
- Custodial exchanges
- Non-custodial exchanges
- Decentralized exchanges (DEXs)
Custodial and non-custodial exchanges are both considered “centralized” exchanges. When an exchange is “centralized”, it means orders are routed and executed by a closed, internal system. The exchange acts as a third-party intermediary between the two trading parties.
With a decentralized exchange, smart contracts replace the third-party intermediary. Smart contracts allow traders to interact directly with one another on a P2P basis without the need for anyone to intervene.
Today, approximately 99% of trading volume flows through centralized exchanges. It’s not a close competition between centralized and decentralized exchanges. That’s why the future shift to decentralized exchanges – if it does occur – could be significant.
Approximately 3 in 4 centralized exchanges are custodial exchanges. A custodial exchanges stores customers’ funds in the exchange’s own cryptocurrency wallets. Coinbase, Bitfinex, Gemini, Bittrex, and other major names all work using this system. In all of these custodial exchanges, customers do not have complete control over their funds. Just like when you store money with a bank, you’re trusting a centralized third-party to keep your funds secure.
Typically, these custodial exchanges manage assets in a similar way. They use an internal ledger. The ledger maps each customer with the coins he or she owns. Customers do not have direct access to the wallets where the exchange stores their assets. Only after selling or transferring assets – like when you withdraw your coins – will the user have control over them.
Custodial exchanges work great in some instances, but there are obvious security concerns. Mt. Gox suffered a devastating hack in 2014. Up until 2014, Mt. Gox was the leading bitcoin exchange in the world and processed over 70% of global bitcoin trading volume. It was a trusted, major name in the industry. Things changed overnight when the exchange lost hundreds of thousands of bitcoins in a hack.
Today, as the market cap of cryptocurrencies continues to grow, exchanges are facing increasing pressure from hackers trying to get access to a growing amount of customer funds. Centralized exchanges pose an increasingly tempting target for hackers – and it’s only a matter of time before one major exchange gets breached.
A Single Exchange Hack Could Push the Community Towards Decentralized Exchanges
Civic Key (CVC) CEO Vinny Lingham tweeted that the catalyst for pushing users towards decentralized exchanges could be a major exchange hack:
“I'm almost certain we will see a top 25 crypto exchange fail or be shut down in the coming months. This will be the catalyst for the emergence of decentralized exchanges and this is a key theme I'm expecting in 2018.”
Today, users have little incentive to migrate to decentralized exchanges. They’re harder to use. They have lower liquidity. There’s limited trading volume outside of the major pairs.
However, if a major exchange – like a top 10 or top 25 exchange – gets hacked and loses customer funds, then the community will be rattled. It could be the catalyst that pushes users towards decentralized exchanges.
What About Non-Custodial Exchanges?
Some believe that decentralized exchanges are the way of the future for the crypto industry. Others, however, believe it will be non-custodial exchanges.
A non-custodial exchange is a centralized exchange with a crucial distinction from custodial exchanges: non-custodial exchanges do not manage users’ wallets. Instead, orders are matched through a centralized order book while the exchange takes a fee off the top.
The best-known non-custodial exchange available today is ShapeShift. The company conducts approximately $10 to $15 million in transaction volume on a daily basis.
Evercoin and Changelly work in a similar way. They offer users the convenience of a centralized exchange – like fast order book matching and enhanced liquidity – with the benefits of a decentralized exchange – like retaining personal control of your funds.
What Does the Future Hold for Decentralized Exchanges?
Decentralized exchanges, or DEXs, are currently a tough sell. They have lower liquidity and lower trading volumes than centralized exchanges.
Nevertheless, decentralized exchanges truly embrace the spirit of the cryptocurrency industry. They allow traders to interact on a P2P basis without the need for a trusted, centralized party. Bitcoin was designed to operate without the control of centralized banks. Decentralized exchanges facilitate that future.
Today, the Waves DEX processes approximately $6 million of daily trading volume, making it one of the largest DEXs in the space.
For DEXs to succeed, they’re going to need to solve crucial problems. Some of the downsides of decentralized exchanges include:
- Low liquidity and trading volume, particularly outside of major trading pairs like BTC and ETH
- Less interoperability than non-custodial exchanges (DEXs depend on a single chain for trading, while most trades take place cross-chain)
- Inability to convert between fiat currency and cryptocurrency
If DEXs are going to play a role in the future of cryptocurrencies, then all of these problems need to be solved.
Conclusion: What About Hybrid Exchanges?
Ultimately, the future of the cryptocurrency exchange industry might not lie in centralized exchanges or decentralized exchanges. It could lie in hybrid exchanges – which borrow some features from centralized exchanges and other features from decentralized exchanges.
It seems inevitable that decentralized exchanges (DEXs) will rise in popularity. However, we’re a long way away from DEXs becoming mainstream. Right now, approximately 99% of trading takes place over centralized exchanges – and it may take a major hacking attack for those trends to be reversed.