Decentralized exchanges, as the name suggests, are cryptocurrency exchanges that operate devoid of a centralized authority. They allow for peer-to-peer exchanges of cryptocurrencies. Everything from capital deposits, order books, order matching, and asset exchange; must be decentralized. However, in most exchanges, only asset exchange is decentralized as they involve cryptocurrencies which are deployed on the blockchain and are, for the most part, beyond the control of a central authority.
The future of decentralized online exchanges is huge, primarily because we’re beginning to see the ability to launch a couple of technologies that are really going to revolutionize things. One of those is atomic swaps.
An atomic swap is where two parties pledge cryptocurrency on each side, in a way that they don’t need a third-party or escrow system. They escrow with each other. Then the code that is needed to release one side guarantees that the other side can release their funds.
If neither side releases the funds, they both get a refund after a time. It’s a basic smart contract using multi-sig and time locks, which is very similar to the type of smart contract you see in payment channels.
Atomic swaps make it possible for two individuals, independently, to swap two cryptocurrencies.
“Atomically”, meaning that it’s all or nothing. Either both transactions go through or neither goes through. Neither party can walk away and steal the currency. They don’t have to trust each other or any third party.
That’s a big development.
The other big development is that Lightning Network can be used for atomic swaps between cryptocurrencies. Effectively, you can create a channel where you send the payment in bitcoin and the other party receives it in Litecoin.
So you can use Lightning Network as an overlay network to exchange crypto-to-crypto. These two developments are going to be very exciting.
Can you have a decentralized exchange with a fiat gateway?
Yes, you can. In fact, it already exists. One example is Bisq. Bisq is a decentralized exchange that runs a peer-to-peer protocol, it runs over Tor, and it allows parties to escrow and then exchanges cryptos for cryptos, as well as cryptocurrencies for national currencies.
Here’s the problem though. There’s a certain degree of risk when you exchange crypto for a national currency. The reason for that is the cryptocurrency side of the trade is non-reversible.
Once you’ve made that payment it cannot be reversed. On the other hand, there is no way to fully guarantee and clear, with absolute finality, the exchange of fiat.
Unless you do it with physical cash.
If you did a fiat to cryptocurrency exchange, where someone mailed cash through the postal service (which is probably illegal in many countries), you could have finality on the fiat side. But then that would expose the person sending fiat to extreme risk, because then why pay the cryptocurrency?
You need an escrow on both ends.
The biggest problem is – if you set it up so that someone makes a cash deposit into your bank account, then you send them the crypto – they can reverse the cash deposits.
You would be surprised at how easy it is to walk into a bank and say, “That was a fraud, I got defrauded.”
“Here’s my deposit slip. I deposited cash into this bank account. Can you please reverse it?”
They will reverse it. They will give you cash back or move it into another account. If you’re the person who just sent cryptocurrency, you’re out of luck. Good luck arguing with your bank. In fact, the moment you walk in and say, “I gave this person cryptocurrency in return for that cash,” they’re probably gonna say, “Oh well. Cryptocurrency? I heard that’s illegal, so we’re not going to help you.”
It’s also possible to reverse PayPal transfers, wire transfers, credit card transactions. There is no limit as to how far back in time you can go, theoretically. A bank can simply pull the money out of your account. If you already spent it from the account, they will still deduct the money and you’ll have a negative balance.
The next time you put money in there, they’re going to take from that. So even if that money isn’t in there, they’ll just take from other money like your wages.
Or they’ll put you in credit, send you letters, and eventually send debt collectors after you. There is no time at which you can say, with absolute finality, that a bank deposit, bank transfer, wire transfer, credit card transfer, or PayPal transfer, is final. No “six confirmations.”
Infinity confirmations are not enough for fiat. It is a soft promise and it can never be a hard promise. That’s why fiat gateways are always riskier. What do people using Bisq do? They take a risk, but as long as it’s a small amount, that might be an acceptable risk.
That doesn’t scale.
Decentralized exchanges are ideal as they operate on the philosophy of cutting out middlemen and interactions happening on a peer-to-peer level, with permissionless models without a centralized authority. These exchanges are censorship-resistant which means that no central authority can impose any regulations forcefully or ban cryptocurrencies even. Without these exchanges, people would have to rely on governments for investing in cryptocurrency. In a situation like this, the government would have unprecedented power over centralized exchanges and authorities may track and tax users or ban currencies. Decentralized exchanges are also highly secure as a result of exchanges repeatedly being hacked, which has led to these exchanges putting maximum emphasis on security.
What’s most important for users is the fact that they are completely and directly in control of their own funds.
This article is a transcription of Andreas Antonopoulos’ explanation on Decentralized Exchanges with FIAT.