According to leading cryptocurrency critic Nouriel Roubini, in 2019, approximately 99% of crypto asset transfers were made on centralized exchanges (CEX). In the foreseeable future, CEX will probably remain a staple in the cryptocurrency trading scene. CEX is fast and convenient, but usually traders are required to deposit money into an account managed by an exchange. Unfortunately, history shows that losing sovereignty over a user’s digital assets can be a serious and costly trade-off.
Desentralized Exchanges (DEXs) offer an interesting alternative and are gaining traction, but they are still not ready to be in prime time. Therefore, there must be a way to bridge the gap between user sovereignty and exchange performance.
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When it comes to custody, control is better than trust.
The nightmare scenario for traders using CEX is that they may fall victim to hacking or fraud and lose their deposits. Although Mt. Gox in 2014, the name is still associated with the risk of cryptocurrency fraud. Once the world’s largest Bitcoin exchange (BTC) filed for bankruptcy in 2014 after Bitcoin lost approximately 650,000 customers. Victims are still trying to get partial compensation from the bankruptcy process in 2021.
Unfortunately, this form of counterparty risk remains a threat to this day. In April, the founder of the Turkish stock exchange, Thodex, fled with an unreported investor fortune of $ 2 billion. The year before, both Chinese FCoin and Australian ACX had closed without notice. Whether these mistakes are the result of fraud, hacks or business model problems, it does not matter to investors who are left without a livelihood. In an ideal world, a stock exchange operator (or a stock market hacker) should be denied the ability to discreetly transfer customer funds between accounts.
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Status Quo: Risk management is costly
For well-capitalized or well-connected traders, there are ways to reduce this risk, but the solutions have their drawbacks.
Credit is one of the ways to avoid having to top up your account in advance. Yes, this is possible if you are willing to pay a high commission to a broker, or if you can get a line of credit from a particular stock exchange and establish yourself as your primary client. It is expensive anyway (or slow in the latter case), and only the biggest sponsors have the chance to create such a good relationship with several exchanges.
OTC billing networks provide an alternative to depositing funds directly on exchanges. These brokers hold the trader’s money and bear the counterparty risk on each exchange. In today’s environment, these intermediaries provide valuable services to organizations, but they still represent an extra layer of costs. It is there for frictionless trade.
DeFi and the issue of transparency
If the problem is the loss of sovereignty over assets on CEX, can DEX be the solution? Yes and no. By using smart contracts and decentralized liquidity pools to exchange assets, DEX removes intermediaries and allows traders to retain control of their assets. However, DEX also offers significant concessions, especially for large traders.
Instead of bringing buyers and sellers together through a central negotiation mechanism, a smart contract performs transactions. Participants, called “breeding farmers”, can lock their assets in a pool of liquidity and receive profits in return. Each pool provides trading liquidity for a specific pair of assets, such as Bitcoin and Tether (USDT). The smart contract will adjust the return according to the relative size of assets in the pool to attract more scarce assets and maintain a healthy balance. At the same time, the transaction fees paid by the trader will vary depending on the relative scarcity of the assets in question.
Although this approach is innovative, it is not appropriate. Depending on the size of the liquidity stock, large trades can immediately have a strong impact on trading fees. In addition, DEXs are very vulnerable to foreground operations. Traders (mostly bots) are the first to lead, looking for information indicating an impending wholesale trade, and then launching their own trades to take advantage of the expected price movement. Of course, these exploiting trades have their own effect on the market price, reducing profits from the originally planned trade. … At CEX, there is a risk that if pre-financing takes place internally, third parties may conclude that a major agreement is about to take place.