June 27, 2019 7 min read
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I invested in BTC in 2010 (and sold shortly after, but have bought and sold all along since then), and have experienced a wild crypto ride. I’ve also advised and been working on a project that has developed the first application to bridge cryptocurrency with augmented reality.
I’ve seen the crypto market on both sides and witnessed the persistent problems of cryptocurrency exchanges, from hacks to insolvency. Institutions and mainstream investors are rightfully hesitant to engage with many exchanges, drawing from mainstream headlines such as the recent Binance hack to the tune of $40 million, as reported by CNBC.
The security woes of centralized exchanges are not the only prominent issue that makes investors and regulators uneasy. Bitfinex’s recent misleading of investors about $850 million locked up, as reported by Coin Desk, with a shady capital firm and the bizarre and ongoing debacle of QuadrigaCX are only a recent spate in a long history of cryptocurrency exchanges mired in dilemmas.
Fortunately, the problems of exchanges are well-known, and many projects, even some exchanges themselves, are working toward providing better trust, transparency and security.
One of the core problems with cryptocurrency exchanges, aptly demonstrated by both QuadrigaCX and Bitfinex, is transparency.
QuadrigaCX was not solvent, and the exchange’s owner was actively siphoning his own funds into customer withdrawals to appear solvent to the customers before his untimely death. Bitfinex, who dipped into its closely-related firm Tether’s reserves to cover an inaccessible $850 million of its funds, failed to disclose this information to customers — and subsequently led to the New York Attorney General filing an injunction against it.
Add in the notion that the vast majority of cryptocurrency exchange actively engage in wash trading and report fake volumes, and transparency clearly is a cardinal issue in the exchange ecosystem.
Transparency primarily involves two areas: proof of solvency and proof of legitimate trading volumes. Proof of solvency is critical because investors need to know the risk of engaging with a financial entity that holds their funds. However, the issue that exchanges take with this is that they do not want to publicly disclose the financial details of their internal operations.
While various degrees of “proof of solvency” has been speculated as a potential scaling advantage for Bitcoin as well, some intriguing technical advances have produced promising glimpses of provable exchange reserves that remain private.
For example, Blockstream — a leading Bitcoin development company — announced its standardized tool for ensuring exchange solvency called “proof of reserves” earlier this year. Essentially, an exchange can prove their reserves of BTC without publicly moving or spending the reserves through generating an extra valid input with a transaction of their total reserves.
All of the UTXOs would consequently become verifiable under the exchange’s ownership without them risking moving the funds since the network would reject the transaction.
However, Blockstream’s proof of reserves still does not preserve privacy entirely, and their team is working on solutions to mask the value of the exchange UTXOs, which would be publicly available.
Other solutions, such as Arpa, take privacy as the foremost consideration. Arpa relies on a fascinating subfield of cryptography called secure multi-party computation, which applied to exchanges, would enable them to jointly compute the average solvency of their exchanges without actually exposing the full solvency data to competitors.
“ARPA’s cutting-edge cryptographic multiparty computation (MPC) disrupts the traditional way of using data, enables privacy-preserving computation or joint analysis of secret data, and replaces trusted data aggregator that captures the most out of the current data value chain, ” as explained by Arpa founder Felix Xu on its site. “Dapps built on ARPA layer 2 solutions across industries like finance, insurance, healthcare and even personal data wallet for secure data exchange and monetization.”
Some exchanges, including Poloniex (owned by Circle), have even begun publishing quarterly reports to provide better assurances of solvency to investors.
Gemini, who also produces the Gemini Dollars stablecoin, has continually emphasized their close relationship with the New York State Department of Financial Services (NYSDFS) to assure investors of both their solvency and legitimacy. And the exchange provides the issuer, banking and security audit information for the Gemini Dollar stablecoin.
Considering the lack of regulatory control over many exchanges located in obscure jurisdictions and their unwillingness to provide better transparency due to the “dark underbelly” money machine, tools such as BTI and Messari 10 can provide better information to investors.
Unfortunately, they still will not solve the fake volumes predicament among exchanges.
Removing centralized custody
Many initiatives in the cryptocurrency sector strive to remove centralized exchanges entirely, or at the very least, their custody. Exchange custody over user funds is an established security threat, and a new generation of trust-minimizing technology and P2P exchanges are working on circumventing centralized custody of funds.
Projects such as Atomic Wallet, a cryptocurrency wallet, focus on deploying a technology called Atomic Swaps. Atomic swaps enable users to exchange assets without third-party custodians ever taking control. The process is entirely P2P and supports cross-chain (i.e., Bitcoin to Ethereum) swaps.
The type of interoperability afforded by atomic swaps is a prevailing trend in the broader cryptocurrency community as well. As more cryptocurrency networks launch looking to provide better scalability, interoperability is also becoming a significant consideration.
Some projects even bypass custody altogether by both users or exchanges. For example, Morpher is a virtual trading platform where users speculate on the market of the underlying asset via Ethereum smart contracts. Smart contracts mint and burn the Morpher token based on the performance of the underlying asset represented by the contract.
As a result, there are no fees and there is theoretically limitless liquidity for any type of market, considering the Morpher token can “morph” into any type of asset. According to Morpher: “If the underlying market gains in value, the smart contract issues new coins to the investor proportionally. If the underlying loses, staked coins are destroyed proportionally.”
The idea of P2P exchanges has also been gaining traction recently, although decentralized exchanges (DEXs) and P2P marketplaces have been around in the crypto sphere for several years.
Traditionally, the problem of P2P marketplaces and DEXs is that their liquidity is insufficient compared to their centralized counterparts, largely excluding them from the partialities of traders.
Despite this, some P2P marketplaces such as Bisq are quickly gathering momentum — in both users and volume. Particularly in economically destitute regions, such as Venezuela, P2P marketplaces such as LocalBitcoins, as reported by Coin Dance, are invaluable to pegging in and out of a store of value when the Bolivar has become effectively worthless.
P2P marketplaces and DEXs still have a long way to go in reaching an optimal level of liquidity but, parallel to the rise of scalability and interoperability, should start becoming more popular among investors in the coming years.
Even some centralized exchanges, such as Binance, are exploring DEXs. Binance’s DEX launched last month, and although it is yet to be seen just how decentralized it will be, it is indicative of Binance’s recognition of the larger trend at hand — users want custody over their funds because they don’t trust exchanges.
The implicit nature of trust makes trusting exchanges all the more difficult considering their history peppered with controversy, but at least projects and the overall industry are beginning to take a hard look at how to improve transparency and remove the need for custody of user funds.
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