The Dawn of Decentralized Finance: Decentralizing Exchanges
By Robin Massini

Sep 14, 2020

Part 2 in a series dedicated to the DeFi boom & Dusk Network’s role in its future

Decentralized Finance, in a nutshell

Decentralized Finance, or DeFi for short, has become a hot topic of discussion inside the blockchain & conventional finance industries. But what is DeFi?

In essence, DeFi aims to improve financial services and sectors as they exist today through revolution instead of evolution, crafting a fresh approach to the status quo processes that have become bloated over the course of decades of incremental change. Certain procedures, intermediaries, fees, and accessibility limitations are (or can be made) redundant with today’s technology. DeFi is the idea that more efficient and effective systems can be put into place.

Today’s article examines the differences between centralized and decentralized exchanges, which of them hews closer to the original intent of cryptocurrency, and the rising demand for trustless protocols for both cryptocurrencies and security tokens.

Cryptocurrency Exchanges: centralizing decentralized assets

There is an inherent paradox to decentralized assets (i.e. cryptocurrencies) finding the majority of its trading occur on centralized platforms. Cryptocurrency as a concept was created as the ultimate financial disruption: the elimination of all intermediaries and middlemen. The idea being that there would be no need to put one’s trust into a centralized authority. So why are the most popular cryptocurrency exchanges all centralized?

In some ways, a centralized exchange represents a step backwards for the primary function of many cryptocurrencies. Much like how DeFi in conventional finance sees its future without banks as custodians of financial assets, the future of DeFi in cryptographic assets seems squarely aimed at achieving peer-to-peer transactions. Instead, users currently see their assets in custody of single entities in total control of the wallets in which the user’s assets are held. In return, benefits to the user (which range from exchange to exchange) include improved User Experiences for trades & transactions, liquidity mechanisms to ensure trading options, fiat-to-crypto (and vice versa) exchange abilities, and insurance in case of loss of funds as a result of hacks.

The cost of convenience

Operating on a centralized exchange means paying the cost of convenience. After all, middlemen are abundant in all of the above-mentioned benefits. Through fees (transaction percentages & flat rates), centralized exchanges can keep the lights on and liquidity flowing. The majority of those new to cryptocurrencies, and indeed most users of cryptocurrencies in general, will gravitate towards the ease-of-use of centralized exchanges. But these exchanges come with their own caveats and vulnerabilities.

For instance, utility requires a level of trust in the central authority. You do not own the private keys to the wallets on which your assets are stored. You have to provide a wealth of personal information. All assets are held by a single entity, which leaves them more vulnerable in the event of hacks as there’s a single point of failure. The exchange is subject to financial regulations, which opens the door to government interventions or complete bans. You also have to contend with a lack of transparency of the central authority’s inner processes.

Centralized exchanges aren’t going away any time soon, nor should they. They provide valuable services that aid in the overall adoption of cryptocurrencies. But we are beginning to see the growth of alternatives that aim to align more with the original conceit for cryptocurrencies; alternatives that believe decentralized assets deserve decentralized exchanges.

DEXes: transactions through automation, not intervention

The most common examples of DeFi usually involve the current banking system in conventional finance. After all, each of us is well acquainted with its uses and friction points. DeFi posits, what if we were all our own bank? No more middlemen, no more fees, no more exemptions based on arbitrary regulations. The differences between centralized exchanges and decentralized exchanges (or DEXes) can be explained in much the same way.

At its core, a DEX provides transaction facilitation through automation, not intervention. No central entity takes hold of your assets and, often, no personal information is required to utilize a DEX beyond a password. Pseudonymity and user privacy are a key tenet of most DEXes as there is no central authority to entrust your personal information to. It is a trustless environment in which you interact with only one party: the contract or individual you’re trading with. Transactions are completed through smart contracts and atomic swaps, meaning there are no deposits or withdrawals. There is no exclusion for certain tokens, thereby expanding the list of trading possibilities. Nodes are spread over the world to power the protocol, which minimizes the possibility of a hack and negates single point governmental regulation. The lack of intermediaries ensures ownership of the assets (and the responsibilities this comes with) is retained by the user.

So why, despite some headlining growth of DEX usage over the past months, do transactions on decentralized exchanges count for only 1% of all cryptocurrency transactions? The main reason for this is the inferior user experience which leads to a lack of adoption which, in turn, leads to a lack of funds for improvement and liquidity which then hampers scalability and spotlights tech limitations faced by DEXes. Mainstream adoption requires an ease-of-use that even the centralized exchanges struggle to provide. Users of a DEX usually have to contend with a user experience in which there is no support service. Account loss is permanent and fully the responsibility of the user. Less services are provided and low liquidity is often a problem. The scalability issues are exacerbated when more people trade on the DEX than anticipated, leading to more load on the network, transaction delays, increase in commissions (where there are any), and other troubling side-effects. These problems are still seen in centralized exchanges, but the singular authority in charge has much greater control over how to alleviate these issues.

Another hot topic reaching the news is the increasing transaction fees on the Ethereum network, mainly due to a relative increase in DEX adoption. With averaging transfer amounts well in the thousands of dollars, rising transaction fees might not seem problematic yet, but will definitely be for mainstream adoption as it imposes serious scalability problems. For DEXes to remedy their scalability problems and thrive, they must first ensure the capabilities of their fundamentals: this means choosing the right blockchain on which the DEX operates.

Dusk Network: the new bedrock for securities exchanges

Each blockchain has its strengths and weaknesses, and every exchange must choose wisely upon which platform their project is built. For instance, Dusk Network’s technical specifications were built as a foundation for decentralization from the get-go, with mechanisms such as our Instant Settlement Finality not only reducing friction in scalability but also measuring up to strict securities regulations.

The most distinctive, and game-changing, feature would be our privacy technology, which allows us to facilitate exchanges that uphold privacy standards, while also being convenient for end-users. It also allows our trustless protocol to be compliant with securities regulations.

First and foremost, Dusk Network is a protocol that preserves the anonymity of users through the use of cryptographic primitives such as zero-knowledge proofs* and commitments. The protocol feature described above enables users to finalize trades without revealing their identities or the amounts being exchanged. User privacy is not only relevant from an individual trader’s perspective, but also a requirement for exchanges trading securities.

*Link to a series of articles introducing and detailing the concept of Zero-Knowledge Proofs

Besides protecting the privacy of individual traders, the Dusk Network protocol brings another major benefit to trading on the blockchain. Present-day DEXes have no means of recovery when a user loses their private key and/or login information, a worry which severely hampers mainstream adoption. Our blockchain, however, does provide such means, as this is yet another requirement for trading securities.

The current market size for DEXes shows there is, and will be, a massive value put into utilizing a trustless protocol as opposed to a centralized database. This need for (and growth in) a trustless environment will not only be seen in Decentralized Cryptocurrency Exchanges but will inevitably be followed by the rising Security Token Exchange sector.

As decentralized exchanges account for only 1% of all cryptocurrency transactions, the total market size of the cryptocurrency market pales in comparison to the present-day securities market. When we look into Euronext for comparison, which is a single stock exchange operator in Europe, it has a total market capitalization of listed companies that is twenty times (x20) larger than the entire cryptocurrency market.** If anything, these stats signal that the best of decentralized finance is yet to come.

**A direct comparison made as of March 2020. Statistics can be found on CoinMarketCap and Statista.

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