A founding principle of this whole cryptocurrency experiment is to extol the benefits of decentralizing the financial system.
“Governments are good at cutting off the heads of a centrally controlled” network, Satoshi Nakamoto, Bitcoin’s creator, wrote in 2008. “But pure P2P [peer-to-peer] networks … seem to be holding their own.”
And, yet, crypto got real centralized. Binance, Coinbase and – before it blew up – FTX grew to be giants of trading, creating a vulnerability if those companies ran into trouble. And they did. Binance and Coinbase face a U.S. regulatory crackdown. FTX famously crumbled last year amid fraud allegations.
There is another way, though, a path mostly known only to traders deeply embedded in the world of crypto: decentralized exchanges (DEX) such as dYdX or Uniswap. And while there are obstacles to more widespread adoption – they are far less user-friendly than centralized exchanges (CEX) like Binance, whose websites and apps closely resemble the brokerage software seen in traditional finance (TradFi) – the investigations into Binance and Coinbase could create a tailwind for these geekier, decentralized finance (DeFi) solutions.
“My best guess is this will further increase DeFi market share as protocols are harder to stop,” said Dave Weisberger, the CEO and co-founder of CoinRoutes. While it’s not impossible to go after DeFi protocols – the U.S. Securities and Exchange Commission just subpoenaed the decentralized autonomous organization (DAO) behind SushiSwap, another DEX – “protocols are harder to prosecute,” he added.
Howard Greenberg, president and co-founder of the American Blockchain and Cryptocurrency Association, also sees DeFi getting a tailwind, arguing the Commodity Futures Trading Commission’s case announced this week against Binance – which was accused of breaking the law by allowing U.S. traders to access its offshore exchange – “may push traders to decentralized alternatives.”
Up until recently, centralized crypto exchanges have been the primary choice for traders looking to buy and sell bitcoin (BTC) and the like. For retail traders, that’s because CEXs can be less intimidating than the apps that serve DeFi. For pros and institutional investors, there’s historically been more liquidity on CEXs, an appealing quality.
Binance, the largest crypto exchange in the world, has a daily trading volume of about $9.3 billion. In comparison, dYdX, the largest DEX, trades around $770 million worth of crypto in a day.
DEXs are intrinsically more transparent than CEXs, given that the former completes trades publicly on a blockchain. CEXs conventionally do not, in part because blockchains simply cannot process transactions fast enough. But blockchains are getting faster. Ironically, DEXs could make regulators’ job easier.
“CEXs being complete black boxes, which almost always creates the uneasy perception of misaligned interests, makes the job of a regulator significantly harder,” said Berk Ozdogan, head of strategy at Dexalot.
“From a regulator’s perspective, trading occurring on public blockchain DEXs means that the effort to prepare formal inquiries, the time needed to conclude the discussions and the trust that needs to be placed on the investigated CEX would no longer be needed since the activity would be readily available for review,” he added.
On DEXs, traders can buy or sell cryptocurrencies without an intermediary, which is typically the part that creates uncertainty because of the limited insight the public gets.
One of the complaints that regulators and even clients of large centralized exchanges have repeatedly expressed is the need for some type of financial audit, a document that proves the company is holding exactly the amount of assets it says it holds. The closest to an audit that most exchanges, such as Binance, have released so far is a proof-of-reserves document, but it can’t nearly be trusted as much.
Audits would be one step closer to the transparency requirements lawmakers are longing for but still far from the level of transparency that DEXs – where every move can be traced on the public blockchain – provide naturally.
“If we learned anything from 2022, particularly with FTX, it’s the fact that custodial relationships, especially in the face of lack of regulation, are very bad,” said Ozdogan. “Too many users have lost assets to bad actors and, in turn, the custodial nature of centralized exchanges. In the world of digital assets, one rule reigns supreme: Not your keys, not your crypto.”