The rapid growth of decentralised exchanges poses new challenges for market regulators and raises new legal questions.
One of the key attributes of blockchains is the ability to achieving a consensus in distributed networks. This allows the Bitcoin network transaction record to be maintained by thousands of servers across the world, without any centralised coordination. It also makes it possible for complex smart contract transactions (such as ones on the Ethereum platform) to be entered into and executed directly by network users.
In this way, blockchain technologies are establishing the foundations for an entirely new economic, social and political reality. One where the distributed network of independent entities is characterised by its highly decentralised nature and an absence of intermediaries who have long played a dominant role in financial markets.
For now, exchanges are centralised…
This bold vision is shared by the creators of many blockchain-driven solutions but it has yet to be realised. The real-life result of the development of cryptocurrencies and other blockchain applications has often been the creation of new centralised institutions despite the theoretical assumptions which suggested the exact opposite.
The most obvious examples of this are cryptocurrency and fiat currency exchanges (and increasingly token exchanges, as discussed here). Most often, these exchanges are traditional companies which create their own centralised exchange platform infrastructure. The companies also store their users’ blockchain assets (cryptocurrencies and tokens) and traditional currencies (USD, Euro, zlotys). The security of these stored assets’ varies – as recent hacking attacks have shown.
These types of exchanges are no longer ignored as marginal entities in the global financial market but have become powerful financial institutions in their own right. The largest of them have a daily transaction volume of several hundred million USD.
The centralised nature of exchanges has another consequence – they are a natural object of government regulations. They represent the gateway between the traditional financial system and the blockchain world. Second, the exchanges compile information about many cryptocurrency and token users. Finally, the way in which the exchanges operate and function resembles the traditional financial institutions’ model. This is why these exchanges are increasingly regulated under anti-money laundering laws (which involves identifying and verifying users), face licensing requirements in a growing number of jurisdictions and are a valuable source of information for tax authorities.
Furthermore, the exchanges must confront regulatory risks for the assets whose exchange they facilitate. For example, one of the biggest unresolved questions about tokens is their potential status as securities (more on this subject here). If a token traded on a particular exchange becomes qualified as a financial instrument, then that exchange may be charged with conducting trading in financial instruments without a proper license.
…but that may soon change
For all of the reasons listed above, work on creating decentralised exchanges has been ongoing for years. These efforts were boosted by the recent growth of Ethereum and similar blockchains, and the increase in assets which can be traded (e.g. Ethereum ERC20 Tokens).
Unlike traditional centralised exchanges, decentralised exchanges are not run by specific legal entities and their users don’t need to entrust their assets to third parties. Trading is conducted directly (peer to peer) between specific users without the need for a trusted third-party intermediary.
Existing decentralised exchanges such as BitShares, OasisDEX and EtherDelta remain fringe players in the exchange of blockchain assets. They face numerous technological challenges, especially ones related to scalability. Business issues also remain unresolved, including the issue of liquidity. Another stumbling block is the lack of traditional currencies which have a blockchain-native presence. While centralised exchanges accept traditional currencies and bank transfers today’s automated and decentralised exchanges cannot do so. Several projects currently under development (e.g. Tether and MakerDAO) take differing approaches to linking traditional currencies (or other stable stores of value) with the blockchain.
Additionally, more ambitious projects in this area, such as 0x, AirSwap, openANX and Kyber, are being developed. These newer projects are not focused on developing simple decentralised exchanges made up of a front-end and relatively uncomplicated smart contracts but, rather, seek to develop complex token exchange protocols capable of forming a new, distributed infrastructure for the exchange of blockchain assets.
Opportunities and legal risks related to decentralised exchanges
The growth of decentralised exchanges gives rise to both opportunities and risks. By eliminating the need to rely on trusted third-party intermediaries, these solutions decrease the high micro-systemic risk of the loss of users’ assets in a collapse of a particular exchange. However, the establishment of new global exchange networks would potentially create new and unknown macro-systemic risks – after all, these solutions would also be subject to hacking attacks and coding errors.
The growth of decentralised exchanges will have a positive impact on the security of transactions by eliminating suspect intermediaries. These transactions would also be easier to monitor as they would be directly registered on the blockchain and not through the exchanges’ opaque internal mechanisms. Ironically, improved transparency may result in difficulties in implementing anti-money laundering regulations.Current AML regulations often task the entity conducting a trade with identifying users and analysing their transactions, under the decentralised exchange system there are no such entities.
Decentralised exchanges also present a difficulty in identifying the entity responsible for implementing various regulations (such as consumer protection measures for the trading parties). However, this difficulty will most likely be resolved in some acceptable manner.
Decentralised exchanges represent the long-awaited next step in the development of public blockchains. They are also yet another reason why potential regulations of blockchain technology should not exclusively focus on its current applications. Existing exchanges are now a focal point of regulatory and public institution interest, but soon they may be replaced with new solutions which could be even more difficult to regulate.