The reason formal centralized exchanges exist within the crypto and wider financial system is simple. It all boils down to trust, reputation and ease of access to a given market. When a single entity manages the transfer of assets between 3rd parties it reduces a lot of the opportunities for confusion and fraud. New blockchain based technology seeks to replace these centralized exchanges by creating decentralized systems where trust is built in via smart contracts. You simply cannot break the terms of the agreement. If a transaction does not complete, then funds are returned to the original parties.
Centralized crypto exchanges are efficient and currently the primary method of transacting crypto-assets. However, several exchanges have collapsed due to hacks, fraud and general mismanagement. Many investors have seen their funds disappear. These centralized exchanges are also vulnerable to restrictive changes in government legislation. An investor may well find that their funds have been appropriated by the government under which that exchange has chosen to be regulated. Well-built distributed exchanges should remove the possibility of the loss of funds as you never relinquish control of your funds to a 3rd party and there is no one place nor jurisdiction within which the exchange operates.
The speed and efficiency of blockchain based exchanges are immediately apparent with the traditional stock market system, taking up to three days to clear and settle a trade (T3). Several major stock exchanges are working on their own systems using blockchain to facilitate increased speed of transactions. However, these systems whilst built on blockchain will not offer a truly decentralised experience. Exchange owners will seek to ring fence their existing market, limiting the types of stocks/commodities etc that can be traded on the platform and giving the owners of this technology the ability to manage who can operate on the networks.
Regulators worldwide are struggling with the problem of how to regulate cryptocurrency transactions, ICOs and cryptocurrency trading on online exchanges. The concerns range from investor protection to preventing money laundering. As regulation looms we are witnessing the rise of decentralized crypto-exchanges. Governments will naturally be keen to attempt to regulate disruptive technologies like this that could have such dramatic consequences for the world’s stock markets. However, due to the supranational decentralized nature of these new exchanges they will be almost impossible to eradicate. The most likely outcome is that the first fully approved and regulated blockchain based exchanges will be offered by today’s major players in equities. Governments will at some point attempt to move against ICOs occurring outside their regulated platforms.
How governments chose to regulate crypto is going to have a major impact on how exchanges evolve. China issued a blanket ban on all ICOs in September 2017. This will force all crypto traders in China towards illicit DEXs providing a welcome boost to distributed platforms.
In Japan The Financial Services Authority (Japan’s regulatory authority) , responded to the theft in 2014 of US$437 million worth of bitcoin from crypto exchange Mt Gox by establishing clear regulations governing cryptocurrency trading exchanges, rather than shutting exchanges down completely. The Japanese tax cryptocurrencies and estimates put tax revenue from cryptocurrency businesses (including capital gains tax from cryptocurrencies made by individuals and corporations), in the region of JP¥1 trillion or US$9.18 billion.
By far the most common approach to regulating cryptocurrencies and ICOs is by using existing laws and regulations. Hong Kong, the US, the UK and Singapore have taken this approach, although the Monetary Authority of Singapore is working on a new Payment Services Bill, which aims to impose licensing requirements on cryptocurrency trading platforms. The problem is that existing financial regulations were written long before the advent of ICOs and trying to place cryptocurrencies into these existing frameworks may not work.
Limiting access to certain crypto-assets and controlling who can use these trading platforms through regulation may appear to the technologically minded, as being a restrictive practice. However, it will also allow new start-ups to tap into and take advantage of the vast amount of investment that can come from allowing their shares / coin offerings to make up parts of existing investment funds and other financial products. Until such a time as the cryptocurrency market starts to mature it may well make sense for ICOs to operate exclusively through regulated exchanges ensuring their access to the world’s capital markets, legitimizing their projects and protecting them from future legislation that may seek to restrict the ability of organisation to raise funds or even ban organisations that trade on decentralised exchanges.
In the short term, at least we are likely to see traditional stock exchanges convert into hybrids of the traditional model and formal blockchain exchanges. Whilst distributed exchanges attempt to compete with centralized crypto exchanges. Governments are very aware that their ability to preside over and regulate the activities of distributed exchanges will be massively diminished. Whilst we wait for legislation to catch up with technology many distributed exchanges are going to remain on the fringe rather than in the mainstream of the financial ecosystem. Until the legal consequences of participating in these types of exchange become clear, or government is so significantly changed by technology that it is no longer within their remit to regulate financial products and services, there will be a place for both distributed/blockchain type exchanges and our traditional formal type of exchange.