In April this year, Adena Friedman, the Chief Executive Officer (CEO) of Nasdaq, the world’s second-largest stock exchange with a $9 trillion market cap, announced that if “people are ready for a more regulated market, for something that provides a fair experience for investors, certainly Nasdaq would consider becoming a crypto exchange, over time.”
The worlds of both centralised and decentralised crypto exchanges are set to continue to compete and merge in coming years, as the exchange business continues to prove its place as the most mature and competitive segment of the crypto economy.
So, what competitive advantages does the decentralised exchange offer, and what are the obstacles in the way of the decentralised model becoming mainstream as it vies for a greater share of the market?
“A decentralised exchange is an open platform for people to share their trading intentions, it has no controlling parties to regulate and oversee transactions,” explains Feng Bo, CoinBene Brazil CEO and Global Vice President.
“Traditional exchanges are formally organised and secured by a group of people that have the best interest of the platforms’ users and listed digital assets.
“The difference between those business models is not a criteria or standard to evaluate an exchange, it’s just a technical infrastructure,” he believes this doesn’t mean “that one is better or worse from the other.”
“The decentralised structure is the technical characteristic of blockchain,” he adds, “but the performance of services on exchanges is not dependant on its structure, but on its operation index: volume, liquidity, safety, user experience and transaction fees.”
Other industry players, however, believe decentralised exchanges hold the promise of rewriting some of the existing inefficiencies created by having intermediaries control the flow of value.
Decentralised exchanges are designed to be trustless, transparent, global, and active 24/7, and could thus go a long way towards creating frictionless global value transfer.
Beyond driving efficiencies, they offer potential for financial freedom for the unbanked as well as a transparent and secure system of exchange.
The hidden rules and fees of banking cartels have long since plagued users of value exchanges – it’s an age-old problem that has blighted the globe for hundreds of years.
The 4th President of the US, James Madison, said: “History records that the money changers have used every form of abuse, intrigue, deceit, and violent means possible to maintain their control over governments by controlling money and its issuance.”
Since decentralised exchanges have potential to be both transparent and secure, they could present a viable alternative and solution to the problem.
Major decentralised exchanges that have emerged on the playing field include Idex, Bitshares, Openledgerdex and Oasisdex.
The 0x protocol aims to provide the infrastructure that will enable the exchange of Ethereum-based tokens under the ERC20 standard (and more recently ERC721), enabling users to exchange tokens directly between one another, rather than going through a centralised exchange service.
But centralised exchanges are fast catching on to the technological disruption, and some have already begun to deliver a blend of old and new models.
Overstock.Com, one of the first of many publicly listed companies globally to do an Initial Coin Offering (ICO), has announced a tie-up with the Boston Exchange via its subsidiary tZero — a crypto exchange trading security tokens.
“This will help tokens to comply with some of the SEC regulations and is a very positive move for tokens, as well as a healthy sign that the ICO market is maturing, says Jonny Fry, co-founder and CEO of TeamBlockchain.
“After all, many people have believed that in reality a significant majority of cryptocurrencies are not utility tokens, but are security tokens, and need an exchange to be listed on.”
Decentralised exchanges bring fresh ideas, possibilities, and competition to the market but they have yet to attract significant volumes of sophisticated investors.
Meanwhile, the Over the Counter (OTC) market has remained very active as an alternative way for institutions and HNW sophisticated investors to trade cryptocurrencies’ tokens. Some organisations are reportedly seeing trading volumes of $100 million of trades a day.
The Goldman Sachs Group owned CircleInternet Financial is one of the best-known firms in this market and “another sign of how institutions are embracing the new asset class that ICOs have created,” says Fry.
“A regulated exchange, which can trade security tokens, could act as a possible gate keeper and offer global regulators some comfort, but only if the exchanges allow clients to use the exchange, provided they have completed appropriate KYC and AML checks,” he says.
Challenges facing decentralised trading & exchanges
Burgeoning decentralised exchanges are faced with having to address a number of challenges as they seek to scale up globally.
Crypto exchanges have often shied away from listing security tokens, as this could have meant the exchange itself would need to be regulated and firms issuing the tokens would also have had to comply with regulation.
But Fry says “It has been a little like the emperor who has no clothes, or the analogy that “if it looks like a duck, swims like a duck quacks like a duck…it is probably a duck”. If you are raising capital using an ICO for a company that is going to build/create a business and turn it from an idea to something tangible, then it is likely the token you create will be a security.
“Although it is ironic that once the ICO has raised capital to build software or some type of organisation, many will need a way to access/power the organisation i.e. a utility token.
“So, there is a body of evidence to argue that many tokens initially need to be treated, listed and traded as a security token, and then potentially will become a utility token.”
So, decentralised exchanges will need to comply with security regulations such as the U.S.’ SEC or the UK’s FCA, “as you could find yourself carrying out an Initial Public Offering (IPO) and being like Apple, Google, BP or Facebook, a publicly listed security,” says Fry.
A further challenge is how to make the whole user experience of buying tokens more user friendly, without the need to have private keys and hot and cold wallets?
The industry also needs to address issues of custody: who and how can a third party hold digital assets? Fry says this is vital for crypto funds to be able to evolve.
“While the technology of blockchain that powers many tokens was designed to decentralise the economy, the ability to have an organisation to look after your tokens that can be trusted is still appealing for many. A fund offers investors the ability to have a true spread of managed or index tracking crypto exposure,” he explains.
Circle Internet Financial has made attempts to offer investors a spread of exposure to different cryptocurrencies, and although there are hedge funds and other specialist vehicles being created, these are typically not available to the public.
It’s currently not possible to offer a regulated mutual fund/OEIC/Unit Trust to the public, as these vehicles need to have the majority of their assets invested in recognised securities.
These recognised securities need to be traded on recognised, or regulated, exchanges which ideally are able to provide fair prices, liquidity and the ability to buy and sell these securities, so the asset managers can value the funds they are managing.
Advantages of a decentralised model
While regulations have been created to protect investors, in reality there are many securities/equities, particularly quoted smaller companies, that have a listing with very little daily liquidity.
“Arguably they offer little comfort that the price which is quoted, is the price that can be traded at,” explains Fry.
Many cryptocurrencies, however, boast a much higher daily turnover of people buying and selling than many publicly listed companies.
In addition, while securities are usually listed on one stock exchange, cryptocurrencies are often traded on multiple exchanges globally.
Even for the most valuable companies by market capitalisation, such as Amazon, Apple, ExxonMobile, and Microsoft, which may be listed across NewYork, Tokyo and London, trading is limited by the stock exchanges closing every Friday evening in New York, before the stock market opens again Monday morning in Tokyo.
“Contrast this with crypto exchanges, where you have the ability to trade 24/7, and often by using several different exchanges that are located across the world,” says Fry, “so tZero’s announcement with the Boston Stock Exchange is a significant step forward.
“It potentially will allow cryptocurrencies to be traded on a regulated exchange, which in time may be recognised,” he says, and so “allow institutions who are currently managing over $80 trillion according to Goldman Sachs and heading to $100 trillion, to start moving some of this capital into cryptocurrencies.
“What impact will this have on the crypto market and ICOs as more institutions embrace this new asset class?”