How to Think About Centralization vs. Decentralization

Centralized Exchanges can steal your money

My friend Jackson Palmer, the founder of Dogecoin made this useful video about Decentralized Exchanges:

I’m writing this piece to talk about exchanges and how to think about decentralization.

I love the word “decentralize” it just feels sexy. But what does it mean? The word decentralize is a transitive verb. This means that you have to decentralize something. So what are the things in an exchange can you decentralize?

Your wallet’s private keys The computing that supports the exchange transaction The ownership of the exchange itself

Without being able to reason about the importance of these three things, you can’t understand what a centralized vs a decentralized exchange is.

Also-you wont be able to understand how your exchange can steal your money. My thesis is that any exchange that owns your wallet’s private keys is able to steal money from you, and there are many cases of this actually happening.

Who owns your wallet private keys?

This question isn’t even really technically correct. If someone controls your wallet’s private keys, it isn’t even your wallet anymore.

This aspect of decentralization, item 1 is simply the most important aspect of centralization. If you give away your private keys, you deserve whatever you get. Unfortunately, most popular exchanges that you create an account in work this way.

This includes:

MTGox

Kraken

Bittrex

Poloniex

Liqui

Gemini

Coinbase

GDax

and many more. This is pretty much all of the most popular exchanges.

So if these people own your private keys, they own your cryptos.

How can they steal your money?

Flat out taking it: The example of MTGox is telling. In 2014, 850,000 bitcoins disappeared from MTGox. The fact that the exchange controls your private keys means they own your cryptos. Full stop. They can be controlled by governments: Bitcoin is decentralized. This means that if the Government comes to your house, they cant “freeze” your Bitcoin accounts if you control the keys. In fact they can’t even prove you have any Bitcoin (or any other cryptocurrency) if you have the keys in a safe location. This enables the government to subpoena records, tax at the exchange or generally do whatever they want. They can be hacked: Bithumb, Korea’s largest exchange was hacked. Holding a large pile of private keys in a database enables customer data and possibly even keys to be compromised. You can be subjected to random “policies”: During the BitCoin Cash fork, Coinbase said they did not want to “support” the fork. What does this mean exactly? Well, during the fork, every single bitcoin wallet was replicated and the wallet owner would then have two wallets, a Bitcoin Cash wallet and a Bitcoin wallet, each with the same number of coins. Although Coinbase eventually succumbed to pressure, they resisted doing so for weeks. What would have happened to the Bitcoin Cash that was associated with all of those wallets? You can be sure that Coinbase would find a way to put those coins in their pocket. Unexplained “outages” may happen: Many exchanges like Coinbase have mysteriously “frozen” during periods of volatility. If the exchange is down, you have no way to access your cryptos. The disturbing idea here is that if the market is crashing, you can’t sell, and if it’s climbing you can’t buy. The ability of an exchange to “crash” at convenient times may actually be the source of a huge amount of revenue for them. For example, if a high volume exchange prevents buying by “crashing” they could potentially trade on a separate exchange ahead of restoring their own exchange, thus allowing them to buy ahead of a large group of people.

There are exchanges that do not require an account and do NOT hold your private keys including Shapeshift and Evercoin (disclosure, I am a cofounder of Evercoin). Both Shapeshift and Evercoin are semi-centralized with respect to 2 (where the computing is executed) and centralized with respect to ownership of the exchange. I say “semi-centralized” because the ordering is centralized whereas the execution of the order is done on the blockchain, which is decentralized (obviously different altcoins have varying degrees of centralization so your mileage may vary, for example Dash which contains master nodes, or Ripple which also has elements of centralization. But generally blockchains are considered decentralized.)

Fully Decentralized Exchanges

Fully decentralized exchanges such as Etherdelta already exist, but they are subject to complex manipulation like “frontrunning”. Watch Jackson’s video above to understand.

0x protocol is a protocol that uses an off-chain relay system to resolve the order book relay, and uses their token to incentivize a matching system a bit like mining.

Decentralizing the computing is not really all that salient to users. It’s easy to imagine a decentralized order book. The innovation of 0x protocol is the decentralization of the ownership of the network. This means that anyone can provide exchange services on 0x by setting up a “miner” and be paid to process the off-chain order book. This is also an interesting concept especially if the decentralized ownership means voting rights and governance over the protocol. This is probably the most decentralized because the users and miners can all decide things like how everyone in the network is incentivized, whereas in the centralized ownership model, the profits made are governed by competition (if you charge too much, people will go elsewhere).