Bridging the gap between sovereignty and performance

As early as 2019, estimated According to statistics, 99% of crypto asset transfers occur on centralized exchanges (CEX). Used by major crypto critics Nouriel Roubini. In the foreseeable future, CEX may still be a core component of the crypto trading field. CEX is fast and convenient, but usually requires traders to deposit funds in an account controlled by the exchange. Unfortunately, history shows that losing sovereignty over users’ digital assets can be an extreme and costly compromise.

Decentralized exchange (DEX) provides An interesting choice and is gaining momentum, But not ready for prime time. Therefore, there must be a way to bridge the gap between user sovereignty and exchange performance.

related: During the market crisis in March 2020 and May 2021, DeFi proved to be resilient

When it comes to hosting, control is better than trust

The nightmare scenario for traders using CEX is that they may become victims of hackers or fraud and lose their deposited funds.Although seven years have passed since then Gox in 2014, Its name is still synonymous with the danger of cryptocurrency fraud. Used to be the largest bitcoin in the world (Bitcoin) The exchange filed for bankruptcy in 2014 after an estimated 650,000 customers’ bitcoins disappeared.The victim is still trying Get partial compensation Start with the bankruptcy proceedings in 2021.

Sadly, this form of counterparty risk is still a threat to this day. In April, the founder of the Turkish exchange Thodex Absconding with $2 billion in investor assets The whereabouts are unknown. The year before that, China’s FCoin And Australia’s ACX shut down There is no warning. Whether these failures are due to fraud, hacking, or business model issues, it doesn’t matter to the out-of-pocket investor. In an ideal world, exchange operators (or exchange-breaking hackers) should be denied the ability to transfer customer funds between accounts at will.

related: In the trustless world of cryptocurrency, trust is still necessary

Status: managing risk will bring higher costs

For traders who are well-capitalized or well-connected, there are ways to mitigate these risks, but these solutions also have their own shortcomings.

Credit is a way to avoid having to fund an account in advance. Yes, if you are willing to pay high fees to the broker, or if you can get credit for a particular exchange by establishing yourself as a top customer, then it is possible. Either way, it is expensive (in the latter case, very slow), and only the largest consumer has the opportunity to establish such a good relationship with multiple exchanges.

The over-the-counter settlement network provides an alternative to loading funds directly to the exchange. These intermediaries hold traders’ funds and assume the counterparty risk of each exchange. In the current environment, such intermediaries provide valuable services to institutions, but they still represent additional costs. The frictionless transaction ends here.

DeFi and transparency issues

If the problem is the loss of CEX asset sovereignty, can DEX be the solution? Yes and no.By using smart contracts and Decentralized liquidity pool In order to achieve asset swaps, DEX eliminates intermediaries and enables traders to retain sovereignty over their assets. However, DEX also involves serious compromises, especially for large traders.

On DEX, buyers and sellers are not matched through a centralized matching engine, but transactions are executed by smart contracts. Participants called “income farmers” can lock their assets in a liquidity pool and earn income in return. Each liquidity pool facilitates the trading of specific asset pairs, such as Bitcoin and Tether (USDT), E.g. Smart contracts will adjust the rate of return based on the relative amount of assets in the pool to attract more scarce assets and maintain a healthy balance. At the same time, the transaction fees paid by traders will vary according to the relative scarcity of the assets involved.

Although innovative, this method cannot scale well. Depending on the size of the liquidity pool, large transactions can immediately have a strong impact on transaction fees. In addition, decentralized exchanges are extremely vulnerable to preemption. The front runners are traders (usually robots) who scan information indicating that a large transaction is about to be carried out and then conduct their own transactions to profit from expected price changes. Of course, these exploitative transactions have their own impact on market prices, reducing the profits of the originally planned transactions. On CEX, the risk is that if pre-financing is carried out on the chain, a third party may infer that a large transaction is about to occur. However, when using DEX, these risks are greatly magnified.

Due to network delays in processing transactions, pending transactions may circulate between validating nodes before they are finally submitted to the block. In fact, on the smart contract-based DEX, bids are sent transparently, so the leader only needs to observe the incoming bids and bid with higher fees or less network delay to make a profit. In addition, it may introduce another opportunity for manipulation when the verifier decides the transaction sequence of the blocks they generate.

Therefore, although DEX is a tempting idea and provides an opportunity to earn passive income, they currently do not meet the needs of most traders well.

related: Yield agriculture is a fashion, but DeFi is expected to change the way we interact with money

Can we build a better DEX?

So, without the drawbacks of the existing DEX, can the interests of traders be better protected?

One possible method here is to use the blockchain as a source of trust and combine it with off-chain confidential computing hardware to process order matching. For example, a Trusted Execution Environment (TEE) can establish an isolated area within a computer processor and run separately from a standard operating system that is inaccessible to system administrators.

The matching engine and transaction execution software of the exchange can be placed in the TEE, making it out of the control of the owner of the exchange. Then, each trader can determine the allowance that TEE can use to settle transactions on their behalf, eliminating the need for prepaid funds or intermediaries. In addition, since the matching will be performed off-chain, the risk of preemption will also be reduced.

Think longer-term and combine other emerging technologies, such as Multi-party calculation or Zero-knowledge proof It may be used to achieve similar results, but these methods are not yet mature and difficult to achieve in real-world scenarios.

in conclusion

The need for pre-financing of cryptocurrency exchanges brings problems and risks that pose a major obstacle to the adoption of digital assets. Although DEX provides an innovative alternative that allows traders to control their funds, they also require significant trade-offs. In order to promote the mainstream adoption of digital assets and gain a competitive advantage, cryptocurrency exchanges need to explore ways to protect user sovereignty without compromising performance.

This article does not contain investment advice or recommendations. Every investment and trading action involves risks, and readers should research on their own when making a decision.

The views, thoughts, and opinions expressed here are only those of the author, and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Alain Brunzikoffel Co-founder of Integritee AG, Integritee AG is a hardware confidential computing solution that combines blockchain and a trusted execution environment. He has been active in the blockchain field since 2013. He contributed to Quartierstrom’s peer-to-peer energy market plan and founded Encoiner, a universal basic income project based on encryption. In 2020, he led the team to win the Energy Network Innovation Challenge, which uses a trusted execution environment for off-chain computing.