Centralized exchanges are vulnerable. Here I'll present decentralized trading solutions in layman's terms - and their pros and cons.
Cryptocurrencies like Steem and Bitcoin are mostly traded on web-based exchange platforms. These exchanges are run by individuals and companies.
The problem is that at the moment you deposit your money there, you lose control of it. You must trust the owner and the security measures of the exchange. The platform could get hacked - like Bitfinex - or the owner could even run away with your money. So, it's always a bit of risk involved and you shouldn't use them for large amounts.
But there are also decentralized solutions. They allow to trade #cryptocurrencies to other coins, #fiat currencies and stable #assets. The good news: They really work! They may have some drawbacks, but in theory you are no longer dependent on centralized exchanges anymore.
The solutions are ordered in four categories.
- Level 1 solutions require some trust, but they are transparent and blockchain-based.
- Level 2 solutions have advanced mechanisms that make an attack unlikely and should be safe in most cases.
- Level 3 solutions are completely blockchain-based and trustless and could fail only in extremely rare occasions.
- Level 4 solutions are the Holy Grail. They are as trustless as cryptocurrencies can be - they only fail if the underlying cryptocurrency fails.
All of them are better than centralized exchanges. And: Although it's in its infancy, Level 4 already exists!
Asset exchanges (Level 1)
Asset exchanges allow users of a cryptocurrency to issue assets. That are tokens that can be traded on the blockchain. An asset is similar to a share in a company: They represent a promise from an issuer to the buyer. That's why they are also called IOU (I Owe You), because the issuer owes you that he will fullfill his promise.
This kind of decentralized exchange has been implemented for many cryptocurrencies. Among the most popular are the NXT Asset Exchange, Counterparty, Omni, Ripple and NEM Mosaic. BitShares has some functions of it as well, but we will talk about it later.
One of the use cases is a gateway between cryptocurrencies and fiat currencies like USD or EUR. For example, an issuer can promise that you get one USD for every USD-based asset you buy. An example is TetherUSD. Cryptocurrency-based assets that represent e.g. a Bitcoin are possible the same way.
Pros:
- #Trading occurs on the blockchain and is completely decentralized.
- Order books are transparent. You can always check the demand for an asset. Even if there is a single buyer, then the token has a value. So chances are that if something goes wrong, you can still save, at least, a part of your investment.
Cons:
- You still must trust the issuer of the asset that he will deliver what it promises. You should normally rely on external means, like a known identity of the issuer, his websites, or his reputation in online communities.
- It is not a trustless gateway to other cryptocurrencies or fiat currencies. For example, if you want to buy USD for Bitcoin in a solution like #TetherUSD, you must trust that the issuer will deliver you the real USD if you return him the asset.
App-based decentralized exchanges (Level 2)
A relatively new form of exchanges and marketplaces allow decentralized trading directly between different currencies. They operate as software apps that are completely independent from cryptocurrency clients. In theory, they can deal with all existing cryptocurrencies and online payment solutions.
In these solutions, both parties of a trade have to make a security deposit in BTC or another auxiliary currency. If one of the parties does not fulfill its obligations (e.g. doesn't send the money to the other party) it loses its deposit. So both traders have a strong incentive to carry out the trade correctly.
Introduction to #Bitsquare (credits to Manfred Karrer)
The most well-known solution for currency trading is Bitsquare. It supports trading from Bitcoin to other cryptocurrencies and to online fiat wallets like OKPay. Decentralized marketplaces that are not restricted to currency trading like Bitmarkets and OpenBazaar operate in a similar fashion.
A drawback is that there is an external instance needed to verify the payment if one of the parties does not react. Bitsquare, for example, uses arbiters. To ensure they are trustworthy, they have to deposit a high amount of Bitcoins. They would lose it if they collude with a scammer.
But as cryptocurrency transactions are easily verifiable, it's very easy to discover and punish attacks in most cases. As this is very risky for the scammer, for trades of small and medium amounts the system should be reasonably safe.
Pros
- Trading is decentralized. There is no single point of failure.
- There is a strong incentive for both parties of every trade to fulfill their obligations and send the pacted cryptocurrencies.
Cons
- This system relies on external arbiters that must be trusted. It is possible in theory that an arbiter is colluding with one of the parties of a trade.
Smartcoin exchanges (Level 3)
Smartcoin exchanges are solutions like the #BitShares internal exchange. They are in some way similar to traditional asset exchanges: Trading occurs on the blockchain of a base currency and the order books are transparent.
But #smartcoins differ from traditional assets in that they are pegged to the price of a good by an automated mechanism. These goods can be fiat currencies, other cryptocurrencies or even commodities like gold or oil. The BitUSD and also the Steem Dollar are examples.
Introduction to BitShares (credits to BitShares Videos)
What is the difference to a solution like TetherUSD? Instead of relying on a promise from the issuer, these exchanges have a pegging mechanism integrated into the code. So an asset issuer must follow strict rules that are automatically enforced, or the system itself acts as asset issuer like in Steem.
In most cases the underlying mechanism is a Smart Contract. In BitShares' BitUSD, the asset issuer must make a security deposit (called a collateral) in the base cryptocurrency BitShares. This deposit is larger than the present value of the currency that is tied to this asset. A BitUSD issuer must deposit a collateral that is equivalent to 2 USD, to be able to sell 1 BitUSD.
There must be an additional mechanism because the value of the collateral is not fixed but moves up and down with the price of the base currency. In BitShares, this problem is solved that way: If the price of the collateral is in danger to be worth less than the pegged real asset, then a margin call is triggered and the BitUSD are bought back automatically by the system. In this case, the issuer loses most of his security deposit.
Can go something wrong? It is possible, but very unlikely. Only a massive loss of the value of the base currency in a very short time period can put in danger the peg because the collaterals would not be worth enough to back the asset value.
But if the collateral is 3:1 like in BitShares, then this is very unlikely. Bitcoin, for example, since 2012 had only one event with more than a 50% loss against the USD in one day: the infamous April 2013 crash. Even this crash would not have put in danger a smartcoin system like BitUSD.
Pros
- Trading is #decentralized and order books are transparent, like in traditional blockchain-based asset exchanges.
- A blockchain-based mechanism pegs the value of the Smartcoin to a currency or real-world asset.
Cons
- There is a very low probability that the peg could fail in an extreme value loss of the base currency.
- It's possible that the smartcoin has a slightly different price than the real asset. But the difference should be minimal.
Atomic cross-blockchain trading (Level 4)
This is the Holy Grail of all decentralized trading mechanisms. It is completely trustless and blockchain-based.
It works only for cryptocurrency-to-cryptocurrency trades. But with this mechanism, you could exchange, for example, Steem for Bitcoin in a totally trustless way without any risk. You could also buy smartcoins like BitUSD. You would not even need additional software: Your Steemit web wallet and your Bitcoin client (even a light or web-based one) would be enough.
The good news: It exists already and it works! The bad news: It is a pretty complex software solution, based on a Smart Contract. It must be implemented separately for each blockchain. The first working implementation is ATOMIC by Ciyam. There are only two currencies supporting it directly: #Burstcoin and #Qora.
There is a similar solution called the Blocknet XBridge. It's still in a very early stage, but there have been already some trades carried out.
Pros
- Trading is totally decentralized and trustless. This advantage should outweigh all drawbacks.
Cons
- It's still not very popular and very few cryptocurrencies have implemented it.
- No instant trades possible. Because of the possibility of double spends, the completion of a trade requires confirmations on both blockchains.
- It is not possible to trade fiat currencies with this method. But in theory it would work with smartcoins like the Steem Dollar.
Conclusion
You really don't need centralized exchanges anymore, in most cases.
What should you do if you want to trade cryptocurrencies in a decentralized manner? Here are the most frequent use cases:
- If you want to trade a cryptocurrency to a stable currency, your best bet is a Smartcoin exchange like BitShares' OpenLedger. It provides a nearly totally trustless environment.
- If you want to exchange a cryptocurrency to another (e.g. Steem to Bitcoin), software-based exchanges like Bitsquare are worth looking at. Above all if the amount is not too large, it's reasonably safe. And follow the development of ATOMIC-based solutions.
- To change a cryptocurrency into a real fiat currency, a fiat backed asset on an asset exchange is a good alternative to a centralized exchange. But remember, it's not totally trustless.
This guide is meant as a long-term project. I'm curious about your feedback in the comments! So if I've forgotten a solution, post it and I'll add it - even after the payout.
You have missed an important "con" for BitShares: the peg can be deliberately modified by the BitShares committee.
See https://steemit.com/bitshares/@cyrano.witness/before-entering-into-a-smart-contract--read-the-fine-print as well as https://bitsharestalk.org/index.php/topic,22936.0.html
Sure, you should always read the fine print. but committee acts on behalf of shareholders and in turn, shareholders should act in their best interest, i.e. to increase long-term value of the platform.
That's a good catch! Thanks for that additional information.
That seems a BitShares-specific "con" argument. My intention, however, was to describe the categories of decentralized trading mechanisms, not only the single implementations. BitShares is only an example for the "Smartcoin" category, although it is possible that "smartcoin" is a term used mostly in the BitShares ecosystem.
Yes, that is BitShares-specific.
Which other Smartcoins exist? The only one I'm aware of is SBD, which is safe wrt that issue.
As of existing solutions, for now, I am aware only of these two. But at least one similar solution is in the making - the ethereum-based Maker DAO with the Dai stablecoin, that seems to work pretty similar to the BitUSD.
There is also SuperNet's PAX, another solution in development, although I don't know if it's not vaporware. It works a bit different than BitShares, but their "USD+", as far as I understand it, could be classified as a smartcoin.
Nice in-depth explanation. Looking forward to other entries of this project. Here's an upvote for your troubles.
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@coinphilosopher you were flagged by a worthless gang of trolls, so, I gave you an upvote to counteract it! Enjoy!!
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