Don’t bet on decentralised exchanges becoming the new crypto frontier… – Financial Times


After much self denial, the hypocrisies of the crypto world are finally dawning on even the sector’s greatest delusion-ists. They’re that obvious.

One such hypocrisy is the space’s longstanding claim that crypto removes the need for trusted intermediaries and therefore democratises finance.

Rationalists, like Alphaville, have long pointed out the claim is a load of baloney designed mostly to dupe the ignorant into thinking crypto somehow changes the financial power order when, in reality, it doesn’t at all. Not only has crypto done little to distribute wealth (with the bulk of crypto wealth sitting in the hands of just a very small early adopting minority) or issuance control (the mining pools represent similar centralised forces to banks), it has prompted an explosion in a new class of trusted intermediary.

This new class — wallets and exchange providers mainly — is arguably much less trustworthy than any bank or payment provider, which are at least licensed, regulated, entitled to lender of last resort services and reputation-invested. Nonetheless, due to the tragic user-unfriendliness of the sector, most crypto users are forced to depend on these often highly inexperienced and conflicted outfits, whether they like it or not.

While some businesses (like Coinbase) are keen to forge “trusted” reputations by co-operating with regulatory authorities, the irony that their structures are no different to the conventional broker-dealer models crypto endlessly banged on about displacing cannot be ignored. Users of Coinbase wallets do not control their coins. As a result — by effectively funding Coinbase — they’re exposing themselves to exactly the same sort of risks they would do by funding banks regulated by light-touch jurisdictions.

The cowboy exchanges positioned offshore and away from prying eyes, meanwhile, represent even greater extremes of riskiness. Users trade at their peril and they know it. They might win big, but they might also be defrauded, robbed or conned out of their winnings at any point. More often than not, the system — just like in the card-playing saloons of the Wild West — is stacked against them, because the tables are controlled from the outset by the sector’s greatest rogues and regulatory outlaws. 

The result? Enter the new Holy Grail of crypto: the decentralised exchange. 

This is the latest pipe dream of crypto aficionados, many of whom have realised that to really compete as a trustless intermediary system the sector’s ironic dependence on centralised exchanges needs to be resolved sharpish.

The solution being touted by crypto, however, constitutes even more baloney. Currently it stands as a contrived blend of a peer-to-peer system, an auctioning system and an open-source developer project mostly intended to autonomously manage customer funds in virtual lockups out of the control of any single party. Neither of which is effective, dependable or useful. Accordingly, the chances of decentralised exchanges taking off at large are slim, not least because the structures within them tend to deplete liquidity rather than encourage it.

It is worth noting the growing impetus to develop a decentralised exchange also coincides with ever stronger signals from the Financial Action Task Force (FATF) that all exchanges/wallets [a.k.a virtual asset service providers (VASPs)] will soon have to comply with the same financial crime rules that apply to traditional financial institutions.

But just in case the decentralised exchange does somehow overcome the impossible… some in the policy world are already thinking ahead as to what such an exchange would mean for financial discipline and order. 

On Wednesday RUSI, the UK’s leading defence and security think-tank, noted in a report on preventing criminal abuse of cryptocurrency the challenges such a system might pose to global security and defence (our emphasis):

While some businesses clearly fall within the five categories of VASP activities listed by the FATF, other business models can present regulators with some uncertainty. This is particularly so in the case of peer-to-peer (P2P) exchanges, which have the potential to weaken the role of centralised VASPs and so blunt the effect of governmental regulation. Although the predominance of centralised VASPs mitigates these concerns for now, drawing a justified line between regulated and unregulated activities is essential both as a matter of principle (to ensure that like activities are treated alike) and to anticipate possible displacement of illicit activity towards unregulated businesses.

What they consider constitutes a P2P exchange system, meanwhile, is as follows:

Some P2P exchanges are akin to a forum where buyers and sellers come together, with the added benefit of an escrow facility to prevent scams. Other exchanges operate on the basis of (self-executable) smart contracts and are often known as decentralised exchanges. In its most ambitious manifestation, a P2P exchange can be maintained by a dispersed community of users and therefore be highly resistant to attempts at regulating or closing it down. This can be potentially achieved through the use of a decentralised application (DApp), a software programme based on smart contracts.

RUSI stated that crypto’s propensity to facilitate crime and money laundering has thus far largely been held in check by its greatest and most ironic flaw: its huge dependency on centralised exchanges to make its user friendly and liquid. 

“Most users purchase cryptocurrency from cryptocurrency exchanges, which have become centralised intermediaries akin to banks,” said RUSI, adding that “transactions that take place on a transparent blockchain, such as that of bitcoin, can be traced not only by law enforcement, but also by anyone with access to blockchain tracing capabilities and a dose of curiosity.”

This hints of the bait and switch at the core of the crypto system. Nothing has fundamentally changed in the order of the financial system from the perspective of users who still have to trust intermediaries with their money to draw on money’s key utility functions. The only real change is that everyone’s private transactions can now be traced by the powers that be across the entire system at large, while the dependency on centralised players means standards can be enforced upon these bodies under the threat they would otherwise be shut down (nice one Satoshi! Thanks very much).

Decentralised exchanges, if they ever take off, do stand to change this. But they’re not necessarily immune to enforcement. RUSI, for example, recommended the following:

While persons should not be subject to AML/CTF regulation solely on account of developing software used for P2P exchange of cryptocurrency, persons with meaningful control over a P2P exchange platform should be subject to AML/CTF regulation. A person has meaningful control over a P2P exchange if they can, for instance, unilaterally restrict access to the exchange or discontinue its operation.

In short, whoever creates an exchange — even in a wide volunteer network where there will still be more active developers than others — may be held responsible for AML/KYC failings.

But we think the safer bet is that properly decentralised exchanges (especially the autonomous DApp variety) will only ever be marginal players in the market due to the clear liquidity disadvantages they pose over more centralised alternatives. And from that perspective, they’ll be punitive to criminals and money launderers in their own right.

Related links:
Why there is no such thing as a trustless financial system – FT Alphaville 
Bitcoin companies come of age; start moaning about unfair playing fields – FT Alphaville 


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