The Satoshi Revolution – Chapter 3: Decentralized Exchanges Own the Future
The Satoshi Revolution: A Revolution of Rising
Expectations.
Section 1 : The Trusted Third Party Problem
Chapter 3: Trying to Undo Satoshi
by Wendy McElroy
Decentralized Exchanges Own the Future
(Chapter 3, Part 1)
I was acutely aware that many of the major
problems still plaguing the Bitcoin ecosystem,
including fraudulent services, unreliable
exchanges, and an often surprising lack of
security, were not caused by Bitcoin’s unique
property of decentralization; rather, these issues
are a result of the fact that there was still great
centralization left, in places where it could
potentially quite easily be removed.
—Vitalik Buterin
Decentralized Exchanges Own The Future
Bitcoin eliminates the need for trusted third
parties. (Remember, the word “trusted” here
refers to an intermediary that needs to be
trusted because honesty and competence are
neither assured, nor easily verified. It refers to
an entity that can steal or defraud.) Not
surprisingly, trusted third parties object to being
obsoleted by cryptocurrencies. As Mel Brooks
declared while playing a politician in the movie
“Blazing Saddles,” “We have to protect our phony
baloney jobs, gentlemen!”
One way the government protects its job is to
require people to use a trusted third party that is
under its control: a centralized, licensed
exchange. To be licensed, the exchanges agree
to comply with many of the same rules that
apply to banks, especially the verification of
customers’ identities and the disclosure of
financial information to authorities. No
customer’s privacy or wealth escapes scrutiny.
Then, government attacks both peer-to-peer
transfers and decentralized, unlicensed
exchanges (DEXs) as vehicles of crime which
must also be regulated or outlawed . With the
free-market competition removed, the
government enjoys a monopoly on
cryptocurrency. Or, rather, it comes as close as
possible to a monopoly. The flow of bitcoin
cannot be controlled any more than the traffic in
street drugs. But outlawing an activity does drive
it underground and makes it riskier, which
discourages many or most people.
A false dichotomy is being set up between
centralized exchanges and DEXs; it is false
because it is viable for the two methods of
business to run in parallel, with users deciding
which one they prefer. That will not happen, of
course, because the goal of government is not
choice, but control. It needs a money monopoly
and data in order to tax and to confiscate
wealth. And, so, it uses centralized, licensed
exchanges to fold cryptocurrency into the
existing financial system. This backtracks bitcoin
to the trusted third party problem that it was
designed to solve.
The Case Against Centralized, Licensed
Exchanges
The freedom of early cryptocurrency hinged on
two circumstances that have altered. First,
legislators did not understand the phenomenon,
nor did they take it seriously. Most are still in the
dark, but they grasp at least one aspect:
fortunes are being made, and they want “their”
share. Second, most of the earliest users were
deeply suspicious of government, and zealously
protective of the features of Bitcoin that gave
freedom and privacy, such as decentralization.
As the crypto-community grew, however, it drew
users who focused on financial gain and who
held conventional views of government. To such
people, government approval means
cryptocurrency is going mainstream, which
translates to greater profit. A significant portion
of the community now argues for regulation and
applauds licensing.
What is a centralized exchange? Politically
speaking, there are two types– unlicensed and
licensed—both of which share some
characteristics.
A centralized exchange is a platform through
which customers place orders to buy, sell, or
convert coins, with the exchange being a trusted
third party that facilitates the transaction. Some
exchanges offer sophisticated software by which
customers can speculate in much the same way
as on a stock exchange. Others extend extra
services, such as a prepaid debit card that can
be used at ATM machines. The exchanges
usually profit by charging fees or by taking the
buy/sell spread as a commission.
Centralized exchanges have benefits. They are
easy to use. And people who are familiar with
banks may feel more comfortable with their
finances regulated. The exchanges also have
negatives. Typically, they restrict how or when
funds can be withdrawn, or they ban withdrawals
and hold funds during trades.
When an exchange is licensed, it imposes not
only its internal rules but also those of
government. Centralized, licensed exchanges
introduce at least six unnecessary risks to their
customers: the possible dishonesty of an
exchange, bad actors from outside, identity theft,
incompetence, collapse, and affiliation with
government. Some risks come from being
centralized; some come from being licensed.
Dishonesty of The Exchange : Many customers
hold funds in their accounts rather than in private
wallets. There can be good reasons to do so. For
example, a trader can access and trade funds
more quickly from his account. But holding funds
in an account is dangerous. A coin is a non-
physical presence on a public blockchain; it can
be accessed only by a private key, which is a
string of text. If the private key is not shared,
then only the owner can control the coin. A coin
held in an exchange account, however, is
controlled by the exchange because it has the
private key. Indeed, some centralized exchanges
refuse to release the private key to the account
holder, making the customer trust the exchange
as though it were a bank.
The Japanese exchange Mt. Gox is a dramatic
illustration of why this dependency is dangerous.
Network administrator and CEO Mark Karpelès
purchased Mt. Gox in March, 2011. By the turn
of 2014, it was the world’s largest exchange,
conducting an estimated 70% of all bitcoin
transactions. Then, in February 2014, Mt. Gox
abruptly shut its e-doors and website, before
filing for bankruptcy protection. When a leaked
document forced his hand, Karpelès announced
that some 850,000 bitcoins belonging to Mt. Gox
and its customers were “missing.” (The total was
later reduced when Karpelès found 200,000 coins
in “a forgotten wallet.”)
An independent audit determined the coins had
been stolen over time, beginning several months
after Karpelès had acquired Mt Gox. He has been
arrested twice: in 2015, for data manipulation;
and, in 2016, for embezzlement. The criminal trial
continues, with few people crediting his “not
guilty” plea. Meanwhile, under Japanese
bankruptcy law, Karpelès may soon be a mega-
millionaire due to bitcoin that he still holds. An
October 10, 2017 article in Ars Technica
explained, “Creditors to be paid out at April
2014’s ~$440 per Bitcoin, not Nov. 2017’s ~$
6,500. In an e-mail to Ars, Karpelès wrote that
the ‘proposition’ that he could stand to gain a lot
is based on laws’.” In short, he is pocketing the
profit.
Bad Actors from Outside: Hackers pose a
notorious threat, and centralized exchanges are
vulnerable because they are large, rich targets.
Last July, for example, hackers stole $32 million
in Ether from Etherscan by exploiting a software
vulnerability in the popular wallet, Parity. As
bitcoin.com contributor Jamie Redman pointed
out , “Close to a quarter of a billion dollars in
ether has been drained by either the ‘black hat
exploiters’ or the ‘white hat group’ since the
notorious DAO debacle last year.“ The “black
hats” are the bad actors; the “white hats” are
good actors who protected vulnerable accounts
by temporarily draining them.
Identity Theft: Hackers scoop up personal data
as well as wealth. The risk is due both to
centralization and to licensing. Exchanges collect
personal data to protect themselves from scams.
Licensed ones collect increasingly extensive data
to comply with government requirements. Then,
they share the information with government
agencies, which make the risk factor spike.
Incompetence : Some centralized exchanges have
notoriously buggy software. A November 14,
2017 headline in the Merkle lamented, “ Kraken
Exchange Issues Ruin Another Weekend for
Cryptocurrency Traders
” . The article stated, “Over the past few days,
it’s become pretty obvious Kraken has a lot of
problems it still hasn’t sorted out. Problems like
these have been documented for many years
now, and many complaints can be found all over
social media.” In short, the site crashed. Glitches
are common at exchanges, the article noted,
“Unfortunately, Kraken is not the only platform
dealing with issues of this magnitude.
Particularly when it comes to EUR-based trading,
the number of viable alternatives is pretty small
right now.”
Even security-savvy exchanges rely on the
competence of related software being used, as
the Parity wallet fiasco revealed. The problem
will only worsen as more and more
technologically-unsophisticated people pour into
cryptocurrency to make their fortunes. This
means that people will not have reliable access
to their accounts.
Collapse : Exchanges collapse for many reasons.
Cryptsy, which has closed indefinitely, is a
cautionary tale. In January 2016, Cryptsy
announced:
“Trades and withdrawals will be suspended on
the site indefinately [sic] until some sort of
resolution can be made. Here are our options:
- We shut down the website and file bankruptcy,
letting users file claims via the bankruptcy
process and letting the court make the
disbursements. – or – - Somebody else comes in to purchase and run
Cryptsy while also making good on requested
withdrawals. – or – - If somehow we are able to re-aquire [sic] the
stolen funds, then we allow all withdrawal
requests to process.”
Whether Cryptsy closed because of a reported
theft or because of its own scams is a matter of
debate and lawsuits. But the dilemma of
customers with funds trapped in a defunct
exchange is not debatable. Like customers of
Mt. Gox, they may struggle for years to redeem a
fraction of their own wealth. And that is one of
the best outcomes.
Affiliation with Government : The last risk is to
both the funds and the freedom of account
holders. It is not entirely created by government,
but it is certainly exacerbated by it. By adopting
ID verification and information sharing with the
authorities, licensed exchanges endanger
customers.
Consider privacy, which is a defense not only
against ID thieves but also against government
overreach. Most exchanges in North America and
the UK demand ID verification before they will
open an account. All licensed ones do so and
the process can be quite invasive.
The government’s use of exchanges to invade
privacy and to prosecute is heating up. A
November 14, 2017 article in bitcoin.com warned
of just one incursion against privacy–albeit the
largest one on record in the U.S. “This week the
battle between the U.S. Internal Revenue Service
(IRS) and the San Francisco firm Coinbase is
heating up once again as a U.S. Magistrate
Judge is siding with the tax collector.” The IRS
claims that 900 people or fewer file tax returns
for the past few years out of the appproximately
500,000 Coinbase customers who are U.S.
citizens. And, so, they demand the right to sort
through the personal finances of every U.S.
citizen at Coinbase. (Much more on the threat
posed by government in the next segment of The
Satoshi Revolution.)
The Case for Decentralized, Unlicensed
Exchanges
Fortunately, not all exchanges are equal. Some
are decentralized. Happily, decentralized
exchanges (DEXs) are becoming more popular
due to uncertainty. Legislation on cryptocurrency
is looming and there is little clarity on what
constitutes “a security.” The uncertainty makes
centralized exchanges reluctant to accept the
flood of new coins that are being issued by a
glut of ICOs. DEXs fill this vacuum.
DEXs bypass the trusted third party problem by
not controlling the funds of customers. The
funds are controlled by the DEX users who
transact peer-to-peer through an automated
process. What distinguishes one DEX from
another is largely the method of the automated
transfer.
The DEX EtherDelta illustrates how peer-to-peer
transactions are executed through a unified
smart contract; this self-executing contract uses
cryptographic code to enforce an agreement.
Here is an over-simplified explanation: Customer
A places a resting order–that is, a signed intent-
to-trade that includes a price, a volume, an
expiration date and a signature. It is recorded in
an off-chain book. When Customer B accepts the
trade, he or she sends payment to the on-chain
address of a created smart contract and so
establishes a type of trustless escrow. The smart
contract verifies the trade; for example, it
checks that the accounts have sufficient funds.
Then, if all is correct, it automatically executes
the trade by transferring funds. No trusted third
party is required.
Other DEXs use smart contracts to automatically
match buyers and sellers. That’s when a
standing order to sell matches a standing order
to buy and the transaction is automatically
executed. Still others use proxy tokens, swaps,
and innovative techniques that can be confusing.
[Note: Some people argue that the blockchain
and the smart contract are trusted third parties
in a distributed, inanimate form. But each is
merely a tool, not a person, not an institution.
They cannot act in bad faith. The situation is
akin to using a hammer to make a repair versus
hiring a carpenter. The hammer might be badly
made, but it is still just a tool.]
DEXs can resemble the Wild West because this
is the early stage when rough edges are being
smoothed. The roughness includes buggy code in
some smart contracts, the lack of trading
software, a slower response time, and the
difficulty of navigating sites. Nevertheless, DEXs
avoid the pitfalls of centralized, licensed
exchanges.