The author, Addison Cameron-Huff, is a lawyer who serves as part-time in-house counsel for Decentral. Decentral is Canada’s main decentralized application business development centre.
Bitcoin exchanges are businesses that connect buyers and sellers of Bitcoin to each other and the banking system. Exchanges pose three problems:
- they sometimes go out of business and lose everyone’s money + bitcoins (“counterparty risk”); and,
- they are easy targets for regulation that can be easily and suddenly shut down by authorities (they are “centralized”); and,
- they have a limited number of options for accepting payment (e.g. a US exchange is unlikely to support M-Pesa transfers).
Decentralized Exchanges: Solution?
Many cryptocurrency enthusiasts think decentralized exchanges are the solution to the problems that Bitcoin exchanges currently pose.
A decentralized exchange is an exchange that uses peer-to-peer (P2P) networking technology to enable users to directly trade with each other. Although a regular Bitcoin exchange allows users to trade with each other they can only do so with the exchange as an intermediary.
When thinking about the difference between a decentralized exchange and today’s exchanges, it’s helpful to think about the difference between Napster and BitTorrent. Napster worked by having a central server that every user’s computer checked in order to see what files were available to download from other users. Napster was shut down in 2001 by a court order that forced them to turn off the central servers. BitTorrent can’t be shut down because users connect directly to each other and not through an intermediate central server.
A decentralized Bitcoin exchange would solve problem #2 (see above) because there wouldn’t be a central server. Problem #1 would be solved with respect to the exchange itself but a decentralized exchange would (depending on how it works) probably introduce a new form of counterparty risk: the risk of dealing with other users. Problem #3 would probably also be solved because users could find the payment methods that work for them in their jurisdiction.
At a high level it would appear that decentralized exchanges are the solution to the problems identified at the beginning of this post but the devil is in the details. The devil lies especially in the details of how a decentralized exchange would handle the interface between “fiat” currency (e.g. Canadian dollars) and Bitcoin.
Canadian Dollars to Bitcoin
A hypothetical decentralized Bitcoin exchange would probably operate along these lines for a $ to BTC transaction:
- Alice and Bob agree on price and quantity (e.g. $3000 for 2 bitcoins) through the decentralized order matching system
- Alice sends $3000 to Bob
- Alice sends a message indicating payment sent
- Bob receives $3000
- Bob sends a message indicating payment received
- Bob sends 2 bitcoins to Alice
- Bob sends a message indicating the bitcoins have been sent
- The system marks the transaction as complete
The steps above pose at least three big challenges:
- What does step #2 mean? How will Alice send the money to Bob? Will the decentralized exchange interface with the thousands of payment systems around the world?
- How can Bob be sure that the money he receives in step #4 won’t be taken back by Alice after step #8? If Alice uses a payment method like a credit card then Alice can later reverse the transaction and potentially get back her money and keep the bitcoins. There are very few methods of payment that can’t be reversed.
- How will disputes be handled? What if Alice didn’t actually send the money? What if Bob doesn’t send the bitcoins? How can Alice prove she sent the payment? What if Alice backs out of the transaction before sending payment? Who will be responsible for offline enforcement?
Flickr photo shown on laptop is by @jalavega