VeradiVerdict - What are the benefits of a Decentralized EXchange? - Issue #33
|Paul Veradittakit||Apr 16, 2019|
Hi, I am Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing into blockchain companies and cryptocurrencies. I focus on early stage investments and want to share my thoughts and what’s going on in the industry in this weekly newsletter.
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Pantera recently invested with Initialized Capital and Foundation Capital into Sparkswap, a decentralized exchange built on the Lightning Network, which I wrote about a few issues ago). By being built on Lightning and using atomic swaps, Sparkswap will enable cross-chain trading (not just ERC20 tokens) in a decentralized manner. Below is additional information on the benefits of decentralized exchanges, how Sparkswap works, and what is in store for the company.
• One of the biggest trends in the cryptocurrency space today is exchanges. Users want to acquire cryptocurrencies and tokens for their utility or to speculate on their prices. Exchanges allow users to deposit their own assets, whether cryptocurrency or fiat, trade for the assets they are interested in, and withdraw back out of the exchange later, resolving the transaction on the blockchain.
• The problem with exchanges is that they’re largely insecure. Because exchanges take custody of user funds, they’re a popular target for hackers trying to steal assets. In 2018 alone, nearly $1 billion was stolen from cryptocurrency exchanges en masse, and that figure is only projected to increase as the hype around blockchain intensifies and hackers develop more sophisticated break-in tools.
• Sparkswap offers a unique solution that preserves the speed and simplicity of trading on an exchange without requiring users to give up control of their funds.
• The key to Sparkswap’s speed is that it uses a second-layer network called Lightning, which increases transaction speeds exponentially by using multi-party payment channels and smart contracts linking the entire system together.
• In the future, Sparkswap plans to add support for cryptocurrencies beyond BTC/LTC and build out a more sophisticated, front-end tools for traders beyond its current command-line interface and API. It presents a very promising solution to Bitcoin’s scalability problem while maintaining the integrity and security of the decentralized nature of blockchain.
How do most traders currently interface with cryptocurrency markets?
Currently, the most popular vehicle for trading cryptocurrency is through cryptocurrency exchanges. A cryptocurrency exchange is exactly what it sounds like––a trading venue where people can trade fiat, securities, commodities, etc., but it’s exclusively focused on cryptocurrency markets. Essentially, cryptocurrency exchanges are platforms for users to join and exchange fiat cash for various forms of cryptocurrency. Unlike in traditional markets, most cryptocurrency exchanges take control of user assets and manage the entire trade lifecycle.
Since the inception of Bitcoin, there’s been a rapid increase in the number of trading mechanisms and the forms of cryptocurrency available, and as a result, the number of exchanges have also skyrocketed in recent years. You’ve probably heard of the larger ones like Coinbase, Binance, Kraken, etc., but smaller, more niche exchanges, like Singapore’s DragonEx, have become increasingly popular as well. There’s not much difference between these exchanges at a high level, other than the fact that they offer different products, features, and prices through various mcehanisms of arbitrage.
Why use exchanges, though? Why not just trade cryptocurrency directly on the blockchain itself?
It comes down to two things: efficiency and interoperability.
Cryptocurrency exchanges offer a convenient, fast, and purportedly trusted way for people to exchange various forms of fiat and cryptocurrency. The problem with trading directly on the blockchain itself is that it’s too slow and inefficient. A single transaction hosted on a blockchain can take a long time to verify, due to the infrastructure of the blockchain itself. Every transaction requires multiple miners to verify the digital signatures (think of it as cryptographic keys) for the paying party, the receiving party, and the transaction itself––and blockchain’s integral consensus mechanisms require that this transaction be reflected across the entire blockchain, which can span to thousands and millions of nodes. Thus, if one were to trade their assets directly on the blockchain, they would have to wait a fairly long time to have every transaction verified. This greatly limits the liquidity of cryptocurrency, because traders have to give up control and use of their assets while transactions are being carried out.
This slow process also creates opportunities for one trader to take advantage of another. For example, if the price between two assets move during the course of the trade, one of the traders may decide to back out. This and other flaws in the trading process result in no strong market formation, leading to good pricing for on-chain trading mechanisms.
In addition, trading one cryptocurrency for another frequently means working with two blockchains that need to talk to one another. Interfacing these different blockchains can be quite difficult, and in many cases is an unsolved problem. Fiat represents an even greater interoperability challenge, as they have no native programmability.
Exchanges solve for the problem of poor trading efficiency by taking control of cryptocurrency and fiat that is used for trading. Essentially, the exchange is able to offer near-instantaneous trades to its users because it records the results of the trade internally without moving any funds on the blockchain. When users later withdraw their funds, the net result of all their trades are recorded in a single blockchain transaction. Since all trades are simply recorded internally on the exchange’s books, trading between cryptocurrencies, or between cryptocurrency and fiat, presents no issues. This means that users are able to trade any cryptocurrency at fast transaction speeds and still withdraw funds back to the blockchain.
If exchanges are so great, what’s everyone so freaked out about?
The problem with exchanges is that their whole existence kind of contradicts the reasons behind why bitcoin was invented in the first place. The ethos behind blockchain and cryptocurrency is that everything is decentralized––there’s no one authority like a bank or a government that micromanages everything, and all transactions have to be verified across the entire network which ensures maximum privacy and security. Because exchanges require users to give them control of their funds in order to trade, they re-centralize the whole cryptocurrency system so that everyone has to put their trust in the exchange.
This is particularly problematic because exchanges are susceptible to hacking and theft. In 2018 alone, there were 6 major exchange hacks––3 of which were in the largest 5 exchange hacks of all time. In total, $865 million was stolen from exchanges in 2018, out of the $1.5 billion that’s been stolen from exchanges in the entire history of cryptocurrency. On average, $2.7 million is stolen from cryptocurrency exchanges per day––and that number is only predicted to increase as hackers develop increasingly sophisticated methods to break into exchange security protocols and siphon away funds. Bitcoin is getting more and more popular, and so is the criminal side of it.
So if exchanges are unsafe, and on-chain trading is too slow, what do we do?
That’s where Sparkswap comes in. Sparkswap is essentially a tool that allows for easy, fast, and secure on-chain trading for cryptocurrency traders using one of the most critical developments in blockchain––second-layer networks, more specifically Lightning.
Sparkswap maintains the decentralized aspect of blockchain because it doesn’t actually hold users’ cryptocurrency funds. Instead, Sparkswap has figured out a way to have users trade with each other and process those transactions on the blockchain without taking control of funds or requiring users to trust each other. And since this whole process happens in seconds, it offers all of the speed and convenience of exchanges, with a significantly smaller security risk, because Sparkswap doesn’t hold any user’s funds for hackers to steal.
What’s the Lightning Network?
Here’s a quick overview:
The Lightning Network is a second-layer solution to blockchain’s speed and scalability problem. It runs on top of the blockchain and interfaces between traders and the blockchains to guarantee the security of the blockchain while promising efficiency and convenience to traders. It uses a combination of smart contracts and a tool called payment channels to guarantee these properties.
In a nutshell, Lightning allows two parties to enter into a payment channel and continually exchange funds without recording every single transaction on the blockchain immediately. Once both parties agree to move their funds onto the blockchain, Lightning then moves the net result of all of the transactions to the blockchain and closes the payment channel––this allows the parties to trade with speed as if they were just exchanging cash in person, but also ensures that the transaction history is immutable, recorded, and accurate because both the parties have to agree on the transaction history.
Lightning then uses smart contracts to link these payment channels and allows two parties who have not entered into a payment channel with one another to transact funds through mutual parties that are linked through payment channels. This allows Lightning’s Network to be incredibly expansive and strongly linked, with a fast and light infrastructure. You can read more about the Lightning Network in another blog post, here.
Sparkswap sounds great. What’s next?
So far, Sparkswap has built out a platform to only trade Bitcoin and Litecoin (you might commonly see this as BTC/LTC), but it plans to expand its platform soon to work with more types of cryptocurrency and assets.
Right now, Sparkswap only has a command line interface and API that allows developers and the more tech-savvy traders to use its platform. The API allows for pretty seamless integration with other blockchain applications, which is a huge win for developers that are searching for a fast, trustable solution to Bitcoin’s scalability problem as they build out their products. The command line interface allows traders to exchange and transact funds fairly easily as well, but Sparkswap has plans to build out a more sophisticated application that requires significantly less technical knowledge to trade.
Altogether, Sparkswap is a huge step forward in the space of making cryptocurrency trading more efficient, secure, decentralized, and integrable into other applications. The market’s current reliance on exchanges is extremely risky––especially as the number of exchange hacks only continue to rise and more funds are criminally siphoned off. Sparkswap’s unique use of the Lightning Network to power fast peer-to-peer transactions provides a clear vision for a future where cryptocurrency trading can be completely decentralized and trustable.
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In the Tweets
Last week we laid out 6 unanswered cryptocurrency tax questions. https://t.co/6RV998NxPr
On Monday we briefed policymakers on those issues https://t.co/UXqW66qkFl
Today 21 members of congress sent a letter to the IRS echoing our concerns: https://t.co/R6VenNbLmr
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1/ The @bitfinex Long/Short Ratio is something a number of us use to help gauge sentiment for the broader crypto market, similar to the "put vs call" ratio in the options market.
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You have to give the entrepreneurs in the world of cryptocurrencies credit. After the bursting of the Bitcoin bubble and increased regulatory push back, they’ve developed a new way to raise millions from investors and enthusiasts still dreaming of digital gold.
2019 Version of the Token Taxonomy Act | U.S. Securities And Exchange Commission | Securities Act Of 1933
2019 Version of the Token Taxonomy Act - Read online for free. 2019 Version of the Token Taxonomy Act
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