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The decentralized nature of digital currency networks is one of the main advantages that cryptocurrencies have over fiat currency, as it eliminates third-party risk. Instead of having to trust a financial intermediary with your finances, you can rely on an immutable transaction ledger that is constantly being audited through the use of cryptographic proofs.
When it comes to exchanges, however, the majority of cryptocurrency exchanges are centralized. When depositing funds on an exchange like this, users have to trust the exchange with the private keys of their cryptocurrencies. Every crypto investor knows not to hold large amounts of coins on exchanges.
However, it can be cumbersome and sometimes slow to transfer cryptocurrency from various wallets onto an exchange and back again once the trades have been executed. This delay puts user funds at risk — and centralized bitcoin exchanges have a long history of hacks, collapses, and operational failures.
Probably the most prolific failure of an exchange was when the once largest bitcoin exchange Mt.Gox closed its doors in early 2014. An estimated $460 million dollars were stolen during a hack that pushed the Tokyo-based exchange into bankruptcy. Users who had bitcoins deposited on Mt.Gox have still not received any compensation from the company’s bankruptcy proceedings.
In the same year, popular bitcoin exchange Poloniex announced on the BitcoinTalk forum that it had been hacked. 12.3 percent of the bitcoin deposited on the exchange — worth around $50,000 — were stolen by a hacker who exploited a vulnerability of Poloniex’s withdrawals code.
The prominent European bitcoin exchange Bitstamp was hacked in 2015 when cybercriminals were able to infect the company’s network with malicious code by targeting its employees with phishing emails. The perpetrators were able to steal over 19,000 bitcoins (around $5 million at the time), which caused the exchange to temporarily close while it investigated the matter.
The most popular global peer-to-peer bitcoin exchange, LocalBitcoins, has also not been immune to cyber attacks. In 2015, the exchange was infiltrated by a hacker who was able to steal 17 bitcoin held in user wallets by using keylogger software. While this hack was minor in terms of losses, it illustrates the point that even the largest centralized exchanges are not safe for traders.
In 2016, Hong Kong-based cryptocurrency exchange Bitfinex fell victim to a cyber attack that resulted in the loss of over $72 million dollars worth of user funds. Over 120,000 bitcoins were stolen by a hacker and it is still unclear how the attacker was able to execute this heist. In a controversial move, Bitfinex issued Bitfinex (BFX) tokens to users who lost bitcoins during the cyber attack in a move to ‘pay back’ the victims.
The Case for Decentralized Exchanges
As this brief history of bitcoin exchange security breaches shows, the risks around depositing cryptocurrency on centralized exchanges are a real issue for active crypto traders wanting to quickly capitalize on intra-day market movements. In light of these risks there is a need for a better alternative, and that better alternative is decentralized exchanges.
Centralized exchange users have to be concerned about potential cyber attacks, inside jobs, operational issues, temporary account freezes or closures — as well as sudden withdrawal limit changes or full withdrawal halts. Many centralized exchanges also require lengthy verification processes to comply with KYC regulations, which can be very cumbersome and creates a barrier for many international bitcoin users.
Decentralized exchanges, on the other hand, are not operated by a central authority and are thus considered more secure as they do not provide cybercriminals with centralized points of failure that can be easily compromised. Decentralized exchanges also require no user verification, which facilities user adoption and allows anyone in the world to trade cryptocurrencies.
Additionally, and perhaps most importantly, they allow users to retain full control over their funds as they are not stored on the exchange’s servers but in their own wallets. Furthermore, trade settlement and clearing on decentralized exchanges are run on the blockchain making each trade transparent, auditable and thus more secure.
The decentralized Ethereum exchange EtherDelta, for example, makes use of Ethereum smart contracts to match up buyers and sellers of ether and ERC20-compliant digital tokens. EtherDelta has emerged especially popular for the trading of newly issued ICO tokens that are often not listed on major bitcoin exchanges.
Decentralized exchanges currently only execute a small percentage of trading volumes. EtherDelta’s trading volume, for example, is only 2 percent of the volume of the largest centralized exchange. Nonetheless, the demand for decentralized exchanges is on the rise as investors are increasingly fed up with being at the mercy of centralized exchanges who can halt withdrawals at will (as we saw in China), are regularly victims of cyber attacks and, for the most part, do not insure deposited funds.
While it is hard to imagine the centralized exchanges disappearing altogether, it is very conceivable that decentralized exchanges will experience a boom in the coming years as bitcoin users increasingly seek a trustless peer-to-peer alternative true to the nature of the blockchain to execute their trades.
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