The fast-growing, billion-dollar crypto-exchange industry is quickly becoming a business avenue as huge as the blockchain sector, as they represent a major part of the cryptocurrency market, in the form of providing a platform that facilitates quick buying/selling of digital assets.
Crypto Markets and Equity Markets Have a Huge Fundamental Difference
It’s evident that crypto-exchanges are nowhere near traditional exchange platforms regarding security, scalability, and accountability. However, crypto-exchange owners are seriously looking to amp-up their offerings, in order to prevent any regulatory crackdown.
As opposed to traditional equity or derivative markets, which are backed by real-world physical assets in a separate location, cryptocurrency exchanges hold both the private keys and digital assets of the investors – making this a fundamental security flaw!
To illustrate this point, if an investment firm offers its investors a financial investment, of say, aluminum, the company is bound by law to have the actual metal stored in a highly-secure, insured warehouse, such that any unfortunate case of theft is immediately paid for by insurance. Investors trade a “derivative” of aluminum, and not the metal itself.
To operate similarly, crypto-exchanges must use the assets present in the investor’s wallets, and provide a “derivative” of the total amount of assets held. Instead, the “real” coins are traded and are not secured by any backed-up digital assets. This makes repayment a huge issue in case of exchange solvency due to an unfortunate hack, as evidenced by Mt. Gox’s 2013 bitcoin hack which hasn’t repaid the investors lost funds after five years of the mishap.
Due to this, regulators are heavily coming down on the sector, all in a bid to protect investor funds.
Exchanges Amping Up Security
While most exchanges resort to the minimum industry-standard of holding all tokens in a cold-wallet, others are taking advanced measures and ensuring total compliance with authorities.
An example is the Winklevoss brothers-owned Gemini Exchange, which was granted a security patent on April 12, 2018, covering a detailed system that aims at securing digital transactions via a complex time-stamped hash network
In addition, the exchange announced its partnership with NASDAQ on April to monitor any suspicious trading activity.
While not completely opposed to cryptocurrencies, the U.S.A famously warned exchanges in 2018 about offering any tokens that constitute as “securities,” alongside warning investors about the highly volatile nature of digital assets.
In April 2018, 13 U.S.-based crypto-exchanges received a letter from New York State Attorney General Eric Schneiderman, asking them to provide information about the security measures they have implemented to protect investor funds. In response, Jesse Powell, CEO of Kraken, slammed the attorney’s efforts, adding “licensing, regulation and market manipulation doesn’t matter to most crypto traders.”
The Rise of the DEX
In the wake of regulatory controversies, and affirming to blockchain’s decentralized ethos, a new wave of decentralized cryptocurrency exchanges, or DEX, are emerging.
As a fundamental practice, DEXs do not hold investors assets, instead of providing a peer-to-peer platform for connecting buyers with sellers, closely mimicking a “swap,” as is famous in the traditional finance markets. DEXs also run on their own blockchain, allows investors and regulators alike to view all transactions and trading taking place on the platform.
The advent of DEXs has the cryptocurrency community divided, with some lauding the concept and others bashing its supposed inferiority.
AirSwap’s strategist Sam Tabar believes that traders migrating to the new (DEX) model will be “this year’s big crypto story.” As reported by BTCManager on April 29, 2018, the AirSwap DEX platform traded north of $1 million on its opening day.
Echoing his thoughts is the author of the Handbook of Digital Currency, David Lee, who ascertains that “decentralized venues will in five to ten years become the main avenue for trading cryptocurrencies.”
However, for Chia Hock Lai, president of the Singapore Fintech Association:
“The new types of bourse have their own particular issues, such as an inferior user experience and lower levels of technical support.”
Nations Remain Divided On Crypto
While the massive revenues raked in by cryptocurrency exchanges directly equates to tax earnings by governments, not everyone is proceeding with this narrative in mind.
In 2017, Japan introduced a mandatory licensing system for cryptocurrency exchanges, and Malta, in March 2018, appealed for crypto-businesses to set up shop in the island country.
The magnitude of a hack is massive as well. In January 2018, Japan-based Coincheck was targeted by hackers who made away with $500 million in stolen XEM tokens; a digital currency ranked fourteenth largest by virtue of its total market cap. Hence, exchange security and token holding is a serious issue in this sector.