Centralized exchanges go against the very ethos of blockchain
Blockchain has disrupted existing industries and created new ones altogether, notably in the fin-tech space.
As a means of raising capital, cryptocurrencies and tokenized assets enable faster transactions at a minimal cost.
The market forces driving the value of cryptocurrencies have also spawned new investment instruments and derivatives – exchanges and futures, for instance.
One example of the recent innovations introduced in this space involves Bitcoin futures – which are, in gist, either buy or sell contracts for Bitcoin at a pre-agreed price at a defined date in the future.
This opens the opportunity to trade not on the speculative aspect of Bitcoin itself, but also as a derivative instrument, meaning investors can earn from both a rise or a fall in Bitcoin prices – a good way to hedge one’s portfolio.
Decentralized tech in a centralized environment
Amid all these innovations, a central point of interest would revolve around cryptocurrency exchanges, where traders exchange cryptocurrencies, tokens, and even fiat money.
Exchanges enable users to make trades within a generally fast and secure environment with minimal cost.
While exchanges are an essential part of the crypto ecosystem, there is one glaring concern brought about by how such exchanges have been set up.
According to a study published by TokenInsight, decentralized exchanges account for only 19 per cent of the global crypto exchange ecosystem.
An even more interesting number is that only 1 per cent of transactions goes through decentralized exchanges.
If the main goal of blockchain and crypto were to decentralize things, then such centralized exchanges would go against the very ethos of blockchain.
Who stands to gain from decentralization?
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Looking at things more closely, the bias towards centralized exchanges stems from the perceived notion that these platforms and transactions need oversight – a concept that has trickled down from traditional financial systems.
However, apart from reliance on a centralized authority, such exchanges are prone to single points of failure, too, in terms of security.
Take the case of various centralized exchanges that have fallen victim to hacking attacks due to the centralized nature of their infrastructure and control.
In the financial setting, crypto and blockchain benefit both investors and entrepreneurs in various ways, and here are five fundamental ways that a decentralized exchange would ideally provide such support.
1. Smart contracts should be able to solve regulatory hurdles and obstacles across jurisdictions
Each jurisdiction has its own set of regulations and frameworks put in place for financial transactions and investment instruments.
Due to the fiduciary nature of investments and financial transactions, one can only expect strict and stringent regulatory regimes.
However, when it comes to fin-tech, many countries are still struggling to come up with an effective framework, especially given the rapid pace of development in terms of new technologies and products.
A fully-decentralized mechanism involving smart contracts should ideally resolve the challenge of cross-border transactions, especially if the smart contract can take into consideration the regulatory framework of each country or jurisdiction that will be affected.
For instance, users exchanging crypto assets on a decentralized exchange can incorporate geolocation features, and the smart contract will be the one to enforce any necessary rules.
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Aaron Tsai, Founder and Chief Capitalist at MAS Capital Universal Exchange, Inc. (MASEx), highlights how centralized systems – for instance, those that stem from U.S. regulatory oversight – are on their way to obsolescence.
“The US system is under heavy fire by the rapid adoption of cryptocurrencies and security tokens. This is a seismic shift that disrupts the existing oligopolies of financial institutions in banking, securities and fund management sectors.”
2.Enhanced trade transparency and security
Record-keeping will become increasingly difficult for centralized exchanges, especially with an increasing volume of transactions.
This results in vulnerabilities, which can affect trader confidence. A decentralized exchange ensures better transparency and accountability, which will mean better compliance with financial regulations.
The main purpose of most regulatory frameworks is to ensure transparency and security in transactions – something that is especially appropriate in trading public securities.
However, this is almost technically impossible to do in a centralized setting, especially when there is a potential single point of failure.
A decentralized exchange ensures better uptime, while a distributed consensus mechanism ensures that malicious players cannot game or cheat the system.
3. Faster trade settlements
In an ideal environment, trades of assets (such as shares of stocks) take an instant to complete. In the real world, millions of stock trades happen in mere milliseconds, facilitated by algorithms and systems.
However, the databases that these algorithms have to interface and coordinate with are currently fragmented and messy.
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In addition, having centralized clearinghouses for transactions can result in bottlenecks in transactions.
At major financial centres, it takes two full days to finish settlements, for example. A decentralized approach done through blockchain will provide faster settlement of transactions.
In some cases, a side-chain or off-chain approach can ensure even faster transaction speeds without burdening the main blockchain.
4. Lower costs, lower barriers to entry
Traditional securities exchanges – such as stock markets – often have high barriers to entry, in terms of transaction fees, largely brought about by high fees charged by centralized exchanges or clearinghouses.
With a decentralized approach, it will be the market that will dictate transaction costs (which are very minimal). A tokenized approach to securities will also mean that investments can be made at a fraction of the cost of other traditional securities.
“Smart contracts enable you to create synthetic assets on-chain based on real live ones that can be accessed without friction and from all over the world,” shares Abishek Punia, Investor at Draper Associates. “New applications can be built on top of this globally connected asset database.”
5. Increased liquidity for private equities markets
Related to the previous point, higher barriers to entry with centralized and traditional securities markets makes it difficult for startups and businesses to raise capital. Add to this the often strict regulatory regimes when it comes to participating in capital markets.
Decentralization brought about by blockchain enables firms to tokenize company equities and digitize assets, which can also streamline the process of capital raise for fund managers and investors.
This encourages better liquidity and higher participation from investors. Matters of equity can be directly incorporated into smart contracts, which makes capitalization tables simpler to manage.
Amar Shah, Director at Namana Investments (HK) Ltd and former Managing Director at Morgan Stanley, shares his opinion on this matter:
“As investors seek higher yields, there will be more funds entering the market. The race to seek these yields will divert some of the funds away from more traditional investments. Furthermore, like education and understanding of these products increases, there is likely to be more liquidity for blockchain startups.”
The future of decentralization
“As the industry matures there are likely to be developments based on market forces taking advantage arbitrage opportunities which will bring about some harmonization,” shares Shah.
Offering his personal views on decentralization, he says that “regulators are increasingly consulting with each other and, as a result, there is likely to be some common regulation.”
Tsai, meanwhile, cautions that the current state of things is far from ideal, but he is confident that we are getting there.
“The decentralized technologies need refinement, but it will not take long before we are there.
When that happens current exchanges will be obsolete, regulators will have no choice but to adapt and the financial giants will tumble. It is always difficult for the status quo to lead a revolution, especially one in which their established roles may no longer be needed.”
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