CEX: a failure point in decentralization
Decentralization is one of the three components of the blockchain trilemma, along with scalability and security. CEXs weaken decentralization.
Cryptoeconomics does not require third parties and trust for transactions. Distributed technology with encryption ensures these conditions.
CEXs (centralized exchanges) were initially created to offer the service of buying and selling cryptocurrencies with fiat money.
Then, as the crypto supply grew exponentially, in 2014 they began to offer cryptocurrencies swap.
This gave rise to speculative investment trading which required stablecoins for arbitrage, the most important of which was Tether (USDT), created in 2014.
Recently they have incorporated lending and then staking services for those blockchain PoS.
The best known are Coinbase, Binance, Crypto.com, Kraken, Bitmax, Bitfinex, Huobi and OKEx.
Its advantage is the very high trading speed as it does not operate on a system of network nodes that requires upgrading.
The simplicity it proposes requires that the private keys of the integrated wallets are managed centrally and not by its clients. But in the event that a fraudster gains access to a customer’s credentials through phishing or hacking, they will have direct access to their stored cryptoassets.
Centralized exchanges tend to operate with a single point of failure, be it a central database, wallet or server, and this means greater ease of hacking.
As of today there are a total of 49 hacking events on the most popular exchanges, with funds lost totalling approximately $2.1 billion.
You can see the list at https://cryptosec.info/exchange-hacks/
The success of third generation blockchains with decentralized financial applications, such as Ethereum and Cardano (which will soon be programmable), gave rise to decentralised exchanges, such as Uniswap, Sushiswap, Compound, Curve Finance, Bisq or GDEX.
DEXs (decentralized exchanges) do not rely on internal servers or their own IT infrastructure, but act as a decentralized application (DApp) on a blockchain.
DEXs have mainly two characteristics: anonymity and high security.
In DEX the private keys remain in the possession of the users, all transactions are carried out through the user’s own wallet via smart contracts. All transactions are p2p (peer to peer).
Currently the volume of transactions in CEX is significantly higher than in DEX:
Data: www.coingecko.com 15.Feb.2021
CEXs have the same security, privacy and censorship shortcomings as traditional financial institutions.
While CEXs are subject to scrutiny by the public as well as government authorities, their transparency extends only to basic information because the blockchain industry is still largely unregulated.
CEXs have their own order books that are recorded internally through proprietary private servers and with centralized security processes.
Considering that today the business of CEXs is similar to that of traditional investment banks, charging fees for lending and trading, they need their clients’ funds, it is highly likely that they will use the fractional reserve system.
Fractional reserve is a banking system in which only a fraction of the amount of their clients’ deposits is held as a reserve for immediate availability, based on the fact that depositors do not usually claim all their deposits at the same time.
Evidence that CEXs would employ the fractional reserve system can be seen in the constant service interruptions with servers down, when there are many transactions (FOMO and FUD), making it impossible to access for trading, or also Binance’s recent limitations to withdraw ADAs due to alleged network maintenance.
The lack of transparency of processes and data is further exacerbated by the use of Tether (USDT), the most widely used stablecoin for arbitrage trading.
USDT doubles the daily trading volume of BTC.
Data: 15.Feb.2021 https://coinmarketcap.com
Bitfinex and Tether are companies that share directors, shareholders and management. All Tether issues go through Bitfinex before being distributed to other CEXs.
The company itself has stated, following a controversial audit in 2018, that each USDT is not fully backed by dollars in its accounts, as some is set aside in a basket of assets and loan receivable accounts.
Tether has been described as “the central bank of cryptocurrency trading” (Wall Street Journal article) and “the glue that holds together much of the $375 billion cryptocurrency market” (Bloomberg article).
To assess the risk of Tether, two types of crises can be considered:
1. solvency crisis, when depositors cannot be paid because of a lack of funds, and
2. liquidity (convertibility) crisis, when not all the money is immediately available.
A Tether solvency crisis would have dire consequences for the crypto-ecosystem.
As centralized exchanges have accumulated great wealth and power the crypto ecosystem has questioned whether the mission of “decentralizing the world” has been undermined by excessive centralization.
Traditional exchanges recognise this and are moving towards a hybrid CEX+DEX model. Bitfinex and Binance already have their DEX versions.
Cardano will undoubtedly be the ideal platform for DEX development, bringing much-needed p2p decentralization to cryptoeconomics.
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