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Types of Digital Currency Exchanges

Something I've noticed at conferences a lot lately is a misunderstanding (usually from folks new to the industry) about the various types of Digital Currency Exchange (DCE) that can exist. In this post I want to break down the different types of exchanges I have seen, their benefits, downsides, and features of each.

But before that, a simple definition of what a DCE even is.

What is a Digital Currency Exchange

Quite simply, it is a place that allows the exchange of one currency to a different digital currency.

There is room for argument about having an open orderbook compared to a brokerage-like service, but to keep it simple I'll be leaving out that distinction and focusing mainly on open orderbook digital currency exchanges.

Past that, there are four simple things that exist in all exchanges that are a requirement to function:

Ledger system

There must be an modifiable list somewhere of customer balances that updates after every trade to ensure that funds exist to facilitate a trade.

Fund delivery

There needs to be a mechanism of depositing, withdrawing, and transferring funds from customer to customer after a trade.

Trading engine

Some type of engine (program, smart contract, blockchain itself) that interacts with the above systems in order to facilitate quoting, execution, and delivery of trades safely.

Interaction

Some method for the customer to interface with all of the above functionality in order to use the exchange.

If something has the above functions, it is a DCE, but there are additional different types of DCE's.

Types of Digital Currency Exchanges

I like to categorize them into the following groups:

Traditional Fiat to Crypto Digital Currency Exchange

This one is where exchanges started, and is the type I'm currently employed by. The concept is simple, input fiat, export bitcoin.

Requirements:

To function, there are a couple required pieces:

  • Centralized Organization
  • Centralized Ledger System where customer balances are held
  • Centralized Trading Engine
  • Ability to accept fiat
  • Usually large amounts of government oversight
  • Usually venture backed (due to large initial licensing and fund requirements by banks)

Most governments highly regulate Traditional DCEs mainly because it is the exit point where laundered coins can turn into cash.

This is because cryptocurrency is still mainly viewed as a means of transmission, not an end goal of money laundering itself.

This type of exchange is also incredibly expensive to start (licensure in the US alone requires millions in spend). It also requires a large amount of capital to continue to operate as well as an impressive balance sheet to gain a bank account to hold customer fiat.

Examples:

  • Mt. Gox
  • Tradehill
  • Coinbase
  • bitFlyer
  • Gemini

Benefits

  • A must have requirement to be able to pay rent (at least for now!)
  • The likely entry point for institutions once they enter the market
  • The entry point for any new trader
  • The increased amount of regulation and compliance required means that teams cannot be semi-anonymous, meaning it is less likely that the exchange operators will exit scam and steal customer funds
  • Most of these exchanges are able to get insurance.

Downsides

  • Centralized, so a higher risk for large scale thefts
  • Stricter KYC requirements require more personal info (and time submitting information) in order to trade
  • Due to stricter regulations, usually fewer digital currencies are offered. Incredibly less likely to list newer coins, due to lack of regulator education on the new offering.

Centralized Crypto to Crypto Digital Currency Exchange

If you strip out the fiat requirement, running a DCE becomes much easier.

A crypto to crypto exchange facilitates the transaction of one currency into another. Usually these type of exchanges will have their primary currency as Bitcoin, so all currencies will be traded against BTC.

Some exchanges do have an alternative base pair, like ETH.

Requirements:

To function, there are a couple required pieces:

  • Centralized Organization
  • Centralized Ledger System where customer balances are held
  • Centralized Trading Engine
  • Only crypto pairs
  • A lot more daemons to facilitate withdrawal and deposits across multiple blockchains

Where you are able to strip out the large compliance programs and funding required to gain (at least a majority of) licenses, you replace it with a much higher requirement of technical talent.

Where a centralized DCE only has a couple chains to worry about, crypto to crypto exchanges will list sometimes hundreds of different digital currencies. Most of these digital currencies have their own blockchain, and each of these separate blockchains requires their own program, their own monitoring service, that will allow for deposits and withdrawals. While this might seem simple, exchanges like Poloniex when first starting out lost funds due to the complication in dealing with so many different daemons. Additionally each of those daemons, which were produced by their own blockchain's developers, can contain backdoors to compromise an exchange's systems.

While crypto to crypto exchanges have been around for at least 4 years, they only rose to prominence with the rise of altcoins (digital currencies other than Bitcoin) in the last two years.

Because of their recent relevancy, only jurisdictions with licensing and regulation built specifically around cryptocurrency (New York, Washington, for example) tend to end up regulating them. While some crypto to crypto DCE's started more a grey area, a lot have either shifted to friendly regulatory jurisdictions or have applied for relevant licenses to ensure regulatory compliance. This is also why you see some conventionally crypto to crypto exchanges announcing plans to offer fiat services. The regulatory compliance allows them to gain banking partners to offer fiat.

Examples:

  • Poloniex
  • Shapeshift
  • Binance
  • Bittrex

Benefits

  • Tons of currency pair options, able to list newer coins faster
  • Centralized trading engine usually means faster trades
  • Customer support (if they're not overloaded)
  • Previously lower KYC requirements, but some DCE's

Downsides

  • Need BTC or ETH in order to start trading
  • Some teams operate semi-anonymously, which creates risks for customers
  • Depending on the DCE and their jurisdiction (and the customer's jurisdiction) there is less of a chance of legal recourse.
  • Increased attack surface with an increased amount of hot wallets for different digital currencies

Decentralized Crypto to Crypto Digital Currency Exchange

The crypto space has been abuzz with the possibility of a fully decentralized exchange (DEX). The first place to start, is with a crypto to crypto decentralized exchange. A DEX operates either in a smart contract, or specifically built into a blockchain, to facilitate trades between traders without any centralized parties. Two traders in essence sign a transaction transferring their funds to each other, and it is governed by the network, allowing for essentially trust-less trading. Pretty amazing!

Now, there are a lot of 'decentralized exchanges' out there that are in truth a psuedo-decentralized exchange. The real question is if there is a single point of failure where a DEX could fail. Right now, given that a lot of work is still being done on DEX's, most offerings have a centralized aspect in their infrastructure.

There is one major challenge in creating a crypto to crypto DEX, once you move off the blockchain that your DEX mainly operates on, how do you enforce trades of other digital currencies. There are two main solutions I've seen so far:

Wrapped currencies (or gateway IOUs)

Under this scheme, instead of trading digital currencies directly, you either deposit to a smart contract (preferred), or a centralized party (less preferred) and receive in essence an IOU back. For Ethereum-based DEX's these are called Wrapped tokens (W-ETH or WETH, etc), on the XRP Ledger these are called IOUs.

Once you have a currency that conforms to the blockchain you are on, you can freely start trading it against other digital currencies on the network.

Atomic Swaps

The other option is to do a transaction across chain. The way this works is Alice sends Bob a BTC transaction on the Bitcoin blockchain. Bob sends Alice a LTC transaction on the Litecoin blockchain. Put simply, hidden inside both transactions is the ability to redeem the other 'side'. So if Bob redeems his newly gained funds, Alice is guaranteed to redeem her funds. If either party backs out of the arrangement, the other party can no longer redeem their new funds and the transactions cancel after a day or so. Both transactions are essentially held in escrow until one of the transactions is completed, and in the process of doing so, the funds on the other chain are redeemable. This allows for a swap across two different networks that do not communicate with each other!

Requirements:

  • No single point of failure
  • Trustless trading
  • A decentralized ledger
  • A decentralized fund delivery system
  • A decentralized matching engine (optional)

Benefits

  • No exchange holds onto your funds
  • Usually no or low fees
  • Few regulations since it is a relatively new advancement, which means no KYC requirements for a DEX, very quick set up time

Downsides

  • No regulators or centralized rule maker means no protection from market manipulation, scammers, etc. Buyer very much beware.
  • Requires already owning digital currency to get started.
  • Usually requires a customer to own and trade with their own private key. Chance to lose funds through user error.
  • While a DEX is lauded as more secure, smart contracts and blockchains themselves are failable, and there is a possibility of a vulnerability being present in the DEX
  • I haven't seen any decentralized insurance options yet.
  • Trading is usually fairly slow through a DEX or on a DEX blockchain.

Examples:

  • IDEX
  • The XRPL (made by Ripple)
  • Waves DEX
  • BarterDEX

Decentralized Fiat to Crypto Digital Currency Exchange

This last type of exchange is much harder to actualize. Fiat by definition is centralized, by design held by third parties, and 'decentralized fiat' is almost an oxymoron.

Much like creating a cross chain crypto to crypto trade, to unlock a decentralized fiat to crypto digital currency exchange requires fiat be transformed into a medium that can be secured and transfered by the magic of cryptography.

Two main routes again to get there:

Wrapped Fiat (Stablecoin) (There is no need to be upset)

Tether, TrustToken TUSD, and countless other stablecoins are all vying to become the standard for wrapped fiat.

The sum of it, you deposit your fiat into one of these organization's bank account, trust account, escrow account, or any other number of schemes modeled off of custody (I'm working on another blog post about custody which I'll release soon!) in a traditional financial market and issue a cryptographic token or asset in exchange for the deposited funds.

I think it's arguable that you could create some sort of stabletoken backed by a cryptocurrency, but it would not solve the main issue here that a Decentralized Fiat to Crypto Exchange is trying to solve, which is that initial onboarding issue.

Obviously this ends up creating a cryptographic token backed by a third party (of some sort). The token is only worth 1:1 of its corresponding fiat as long as trust remains solid in that third party.

Government Cryptocurrency

Guaranteed to make real Bitcoin OG's turn to the bottle, the other option for a Fiat to Crypto DEX would be to change the nature of fiat from a government issued slip of paper (or ledger entry at a reserve bank) to a government issued cryptocurrency. Presumably banks (or way far off in the future, reserve DCE's) would help facilitate the redemption or exchange of traditional fiat for this new option. This would be the truest example of a decentralized crypto to fiat DCE. It is obviously still reliant on trust in the government, as all fiat requires, but no other third party would be required in the equation.

Requirements:

  • Some sort of crypto-fiat
  • The beginning of 500 years of darkness for all crypto-anarchists

In Summary

That is... well a much more in-depth overview than I was expecting to get into. But understanding the types of exchanges, their regulatory landscapes, and the options available to customers will help you better understand the market and where the industry is heading towards.

For a new token or coin, starting on a DEX is an option available to every team. Moving up towards newer crypto-to-crypto exchanges that are less regulated is your next step, and your final step once you've actually gotten a stable community and amount of volume behind you is not to reach out to a traditional DCE, but to work with regulators to ensure they allow your coin to exist aside fiat pairs. Stop spending money on marketing and start spending money on lobbying.

This is as in-depth of an article as I could write, if you notice an error or can explain anything in this post better, please mention it in the comments!