/ Ecosystem

Exchanges & The Future of Decentralization

Hodor

Hodor

I blog about Ripple & XRP. FULL DISCLOSURE: All views are my own. I do not work for Ripple; I am not a professional financial analyst, and the majority of my crypto holdings are XRP.

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There is an inherent conflict between individuals and authority throughout multiple areas of our daily lives.  I'll steer clear of specific examples, but suffice it to say that for crypto, the industry has its roots in a strong libertarian vibe that can still be felt within the industry - this energy powers creativity and innovation, but it can also run afoul of traditional authority and established rules.

When it comes to the United States (my own country), it's wise for those of us in the crypto community to keep in mind that the United States reserves the right to regulate all commerce - and this by definition would loosely include innovations like blockchain commerce.

 

In fact, it’s written into our constitution:

 (the United States Congress shall have power) "To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.”
Granted, this was written 1 hundreds of years ago, but it is a right that is still reserved, and I highly doubt that the US government is ready to concede this authority purely based on the power of an innovative new technology like blockchain.

How Does this Apply to Crypto-currency?

Well, up until early September of this year, the possibility of one of the world governments stepping in to try and regulate Bitcoin commerce was just theoretical.  Did anybody really think a government would try and regulate what many in the crypto world had thought was completely censor-proof?

Some might have anticipated it, but when the ICO warning was issued 2 by the United States’ SEC, the thought of another government actually weighing in with tangible sanctions against Bitcoin trading seemed like a remote possibility – one that many people thought was an unlikely scenario.

But it happened.  And it happened fast. ChineseFlag

China issued guidance 3 that all crypto-currency trading from CNY to … any crypto-currency … must stop.  People are still trying to grasp exactly what the sanctions mean in total; some say that all Bitcoin and crypto-currency trading has been outlawed in China, while others believe that over-the-counter exchange of crypto-currency might still be legal. 4 Regardless, the Chinese government has shut off the pipeline of value going from CNY to Bitcoin… or any crypto, for that matter.

Yes, this could happen here.

And where is here?  For me, it’s the United States.  For you, perhaps it’s the United Kingdom, or Australia.  Or France, Germany, India or Japan.  In fact, any countries’ commerce regulators could decide to move against Bitcoin or another crypto-currency.  Wasn’t this stuff supposed to be resistant to all governmental control?  Isn’t that contained in the Bitcoin manifesto 5 itself?  (yes, they call it a ‘manifesto’)

What Will it Take to Truly Make Crypto Censor-Proof?

If you’re truly interested in what it takes to make crypto censor-proof, you have to ask yourself if Bitcoin’s manifesto is really a call to action or if it’s just a blatant marketing ploy to get a specific demographic to invest their crypto-currency.

The reason I might sound cynical is because I’ve seen the trite responses I get when I talk to some in the crypto community about what it truly means to be ‘decentralized’.  Does it mean where the processing power is located geographically to validate transactions?

Is proof-of-work the only legitimate way to secure a crypto network?  Vitalik Buterin doesn’t think so. 6 In his blog, he talks about the differences between consensus algorithms and indicates that the usage of penalties might be a way forward for a new Ethereum consensus using proof-of-stake instead of an ostensibly decentralized proof-of-work algorithm.

Crypto-currency Decentralization is Not a Boolean.  It’s a Continuum.

If you’re an XRP investor, you might be familiar with the obtuse responses from rival Bitcoin supporters that still believe crypto is a win-lose type of marketplace.  They challenge XRP investors to prove that the XRP Ledger is truly decentralized, and then XRP investors respond by pointing out the diverse validator list 7 and the steps that Ripple is taking towards higher levels of decentralization. 8 9 The inevitable response is a ‘gotcha’ type of reaction 10 by the Bitcoin fan; usually gloating accompanied by disparaging statements about XRP being the ‘banking coin.’

What’s the truth?  XRP is heading towards a responsible, stakeholder-led version of decentralization that will be more robust and redundant than Bitcoin or Ethereum when it’s fully realized. 11

Ethereum has serious problems of its own when it comes to decentralization; currently two mining pools control up to 50% if the processing power on the network. 12 If you’re new to crypto-currency, this should concern you, because once a miner (or a mining pool) obtains more than 50% of the processing power, they could in theory submit transactions against any account and approve them, in essence stealing the crypto-graphic tokens from one account and stashing them in another account.  It’s called a “51% attack” for that reason.

Bitcoin suffers from its dependence on Chinese mining pools. 13 From what we’ve just seen, that’s very problematic, because if China wants to shut off Bitcoin at some point in the future – a future that is looking a lot less theoretical by the day – they could influence the Chinese mining pools to accomplish this task.  While I don’t personally believe this would happen, I will note that I also didn’t believe that China would shut off crypto trading within its borders, either.

But these conversations pick away at details; the point is this: Decentralization is not a ‘yes’ or ‘no’.  It’s a ‘how much’ type of question.

Decentralization_Continuum

In programming, this is the difference between a Boolean variable and a quantitative variable.  Despite the arguments that some crypto-anarchists might make, all of the top crypto-currencies – Bitcoin, Ethereum, and XRP – are decentralized, but all of them have not yet achieved the absolute goal of self-sustaining decentralization.

And that’s a weak point for true censorship resistance. 

Dominant ISPs

Concentration of Bitcoin, Ethereum, or XRP nodes within one ISP could also be problematic.  A government might actually resort to attempting to influence the way that a dominant ISP routes traffic.  Concentration of crypto-currency validation on one ISP is a topic that has not been discussed or focused on in many forums; but if true censorship-resistance is what is desired, it should definitely be a topic of the conversation.  Note that hackers have used this technique successfully against Bitcoin in the past. 14

Pipeline Security

Bitcoin transactions are communicated over HTTP un-encrypted. 15 While the end result of any tampering should be detectable by any Bitcoin nodes receiving a corrupted message via a ‘man in the middle’ type of attack, it begs the question;
“if Bitcoin transactions can be identified on a network, can they be essentially shut off in mid-stream by routers within a specific country?”
If the answer is yes, then we’ve just identified another weak point in crypto-currency censorship resistance.

I will take a moment to point out that the XRP Ledger’s transactions are encrypted.  This means that, in theory, XRP transactions should be considered “noise” by any monitoring software. 16 17

While some developers may point out that changes could be made to alter a protocol to prevent detection, it serves to illustrate the difference between the perception of a censor-proof, decentralized network, and the reality of one operating within a country, resistant to those that might try to prevent transactions from even being communicated.

Centralized Exchanges Are the Weakest Point

In its recent proclamations, China pursued the weakest points in the crypto-currency ecosystem – the exchanges where fiat value is exchanged for crypto-currency value. weak_link

If you want to set up a crypto-currency exchange in the United States – or any other country for that matter – it involves setting up a business that utilizes modern technology housed on reliable, fast servers.  Users demand some basics from an exchange:

  1. An easy way to transition their fiat value into crypto value
  2. A way to trade one crypto-currency against another
  3. A way to withdraw their crypto-currency
  4. A way to withdraw their fiat value
If an exchange can provide those four things, they’re in business!  And it’s quite a business – billions of dollars change hands each day now in the crypto markets, which is a phenomenal increase from just one year ago.

The Problem with Centralized Exchanges

When a user sends their money to a centralized exchange, they’re sending their fiat money to a company, ordinarily, that is registered in a specific country and subject to the laws of that country.  This normally means that users can depend on basic business-like activity without unnecessary fear of their fiat money being stolen or misplaced.

Most exchanges now offer secondary authentication, which further reduces a user’s risk of account theft.

Security

But they offer a stationary target for hackers...and the government!

One type of hack is the “inside job” which seemed to happen on a regular basis in crypto’s early years.  Bitcoin’s recent price surge has also resulted in a new wave of centralized exchange hacking, ostensibly from a variety of external actors. 18 Social engineering hackers will employ a variety of tactics to obtain access or trust from their victims; phishing emails is one technique. 19

Users of centralized exchanges are targeted for phishing scams because of the prevalence of personal data that may be transmitted un-encrypted.  In other words, while the exchange worries about keeping your private keys secure, they may not have enough safeguards around information such as your email, name, or even government identification.

Government Reporting

If we’re focused on what would improve the censorship-resistance of crypto trading, we need to talk about the influence of the government.  I’m not talking about any one specific government here, but just its general influence no matter where you happen to reside.

We know that the government has been learning about crypto slowly but surely – they know enough to work with centralized exchanges as a choke point when it comes to regulation.  In the United States, this means KYC, or ‘know your customer.’  It’s done for a number of reasons, whether you agree or disagree with them; a centralized exchange is usually required to obtain identifying information on all purchasers of its financial products like crypto-currency.

Okay, so the centralized exchange knows me.  So what?

This is the controversial part.  It happened last year when the United States government asked Coinbase for a list of all of its US customers. 20 To many, this request set a disturbing legal precedent, because there was no evidence of wrongdoing on the part of Coinbase’s US customers.  It was a “John Doe” summons on the part of the US Government, and the implication was that now the IRS had a list of all US citizens who had an account at Coinbase. coinbase

The irony was not lost on most of us in the crypto community in the United States.  Those of us that went through a centralized exchange were probably also the portion of the crypto trading community that was the least likely to avoid taxes; there are plenty of other untraceable ways to move value into the crypto world.

This move reminded me that governments may be ‘in over their head’; I started to have my doubts that they should even be trying to regulate this market: Perhaps they’re going about it the wrong way – perhaps trying to control flow of money is not the right approach for enforcing policies?

In the end, it’s not a matter of me personally believing that any particular method of enforcement is right or wrong, despite what I feel about Coinbase being forced to give up its member data.  The next part of the discussion is about what is technically possible.  Enter the decentralized exchange.

Decentralized Exchanges

This wasn’t my idea, but this idea was inevitable.  And it serves as a herald of things to come for governments around the world.  While some government policymakers might be sympathetic to China’s new policies against trading CNY for crypto-currency, the truth is that the time is quickly approaching where that ability – the ability for governments being able to restrict this – is going to cease to exist.

How Does it Work?

A decentralized exchange is just that – normally software that runs on somebody’s smart phone or personal computer.  It may be a browser application, or it may be a desktop application – either one will do.

Each user serves as their own ‘fiat-to-crypto’ converter and must agree (somehow) to provide fiat value to others on the decentralized platform in exchange for crypto-currency.  And that’s it – now they’re ready to trade.

It’s not too much to ask – popular smart phone applications like Venmo have similar concepts that users have become accustomed to, like hooking up a funding source – it’s just a matter of the decentralized exchange figuring out their own way of moving fiat and crypto-currency around in a direct peer-to-peer fashion.

Of the key differences between decentralized and centralized exchanges, governments will probably not like the first two:

  • The end-user controls the funds
  • End-users can be anonymous
  • Low(er) risk of hacking
Based on what I’ve seen, I think decentralized exchanges are now going to step into the role that centralized exchanges used to play, and – slowly - take over the market. exchanges

Again, what I think personally of them doesn’t have any bearing on the trend – governments will eventually have to come to terms with the decentralization - and control - of money by their citizens, regardless of the legacy laws that were based on paper-based currency and centralized bank databases.

New Government Enforcement Methods?

There are several short and long-term scenarios for government reaction to the rise of decentralized exchanges.  In my analysis of the various scenarios for new approaches to AML and KYC enforcement, I’ve made several conclusions:
  • The sheer number of decentralized exchanges and methods of fiat conversion will make detection of use infeasible by governments
  • Governments will attempt new approaches to AML (i.e., they won’t just “give up”)
  • Governments will have to collaborate on AML enforcement – i.e., they can’t “do this solo”
  • Governments will focus on any central authority for each crypto-currency (including non-profit foundations)
  • Rise of the importance (and career field) of crypto forensic analysis

Crypto Market Analysis & XRP Impact

Even as you’re reading this, I believe that various governments are contracting with businesses to develop forensic analysis tools for tracing movements of crypto-currency.  It’s not just about being able to view a transaction on the blockchain anymore, or unmask who owns a wallet.  Those things are possible currently, but I predict the development of advanced AI algorithms that can detect and flag specific transactions and accounts for further investigation by enforcement organizations.

I do not believe that XRP will specifically be exempt from any of these rules or enforcement actions; it is through the behavior of the company that gave birth to XRP that XRP investors will see benefits.  I predict that world organizations, central banks, and various government financial organizations will all be utilizing Ripple technology in the very near future – it’s happening already, as we can see from the banking adoption numbers and from the fact that Ripple is hosting the ‘blockchain’ equivalent of SIBOS (at the same time as SIBOS).

Ripple has a history of working with standard organizations 21, central banks 22, the IMF 23, national policy-makers 24, and the United States Faster Payments Task Force. 25 No other company with a digital asset can boast about these types of high-level associations or business alliances.  My educated guess is that when it comes time to craft meaningful new legislation at a national – or international – level, Ripple will be able to help steer the thought process in the right direction.

regulations

Ripple’s real-world experience grappling with regulatory conformance will help governments approach the new world of decentralized currency in ways that make sense and are more effective than coloring all crypto-currency-using citizens with the same paintbrush.

From its earliest start, Ripple took the pragmatic approach of working with established business and governments, along with banks and regulatory agencies.  This experience bodes very well for the company as the SWELL conference approaches; banks and other financial institutions curious about the regulatory landscape for blockchain in the wake of the China pronouncements will be hungry to learn about the smartest path forward in anticipation of future trends like decentralized exchanges. xrp

Sources

  1. https://en.wikipedia.org/wiki/Commerce_Clause
  2. http://fortune.com/2017/07/26/sec-icos/
  3. https://www.bloomberg.com/news/articles/2017-09-11/china-is-said-to-ban-bitcoin-exchanges-while-allowing-otc-trades-j7fofh20
  4. http://fortune.com/2017/09/11/china-bitcoin-exchange-ban-otc-trading/
  5. https://bitcoinfoundation.org/wp-content/uploads/2017/03/Bitcoin_Foundation_Manifesto.pdf
  6. https://medium.com/@VitalikButerin/a-proof-of-stake-design-philosophy-506585978d51
  7. https://xrpcharts.ripple.com/#/validators
  8. https://twitter.com/Cryptity/status/880359331467800576
  9. https://www.americanbanker.com/opinion/ripples-overlooked-path-to-decentralization
  10. https://www.cryptocoinsnews.com/ripple-unveils-strategy-become-decentralized-bitcoin/
  11. https://ripple.com/insights/how-we-are-further-decentralizing-the-ripple-consensus-ledger-rcl-to-bolster-robustness-for-enterprise-use/
  12. https://etherchain.org/statistics/miners (ethpool/ethermine & f2pool control 51 % of all ether processing power)
  13. https://www.buybitcoinworldwide.com/mining/pools/
  14. https://www.theguardian.com/technology/2014/aug/07/hacker-bitcoin-mining-pool-internet-service-providers-canada-dell
  15. https://en.bitcoin.it/wiki/Transaction
  16. https://www.xrpchat.com/topic/9556-routing-attacks/?do=findComment&comment=94579
  17. https://www.xrpchat.com/topic/9556-routing-attacks/?do=findComment&comment=94578
  18. https://www.cnbc.com/2017/06/14/major-bitcoin-exchanges-hit-by-cyberattacks-as-record-rally-makes-them-a-target.html
  19. https://en.wikipedia.org/wiki/Social_engineering_(security)
  20. https://dcebrief.com/irs-argues-coinbase-users-cannot-challenge-john-doe-summons/
  21. https://www.w3.org/community/interledger/
  22. https://www.coindesk.com/uk-central-bank-tests-ripples-interledger-protocol-cross-border-payments/
  23. https://www.imf.org/en/News/Articles/2017/03/15/pr1784-imf-managing-director-welcomes-establishment-of-high-level-advisory-group-on-fintech
  24. https://ripple.com/insights/ripple-comments-occ-paper/
  25. https://ripple.com/insights/federal-reserve-task-force-ripple-improves-speed-transparency-global-payments/

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Hodor

Hodor

I blog about Ripple & XRP. FULL DISCLOSURE: All views are my own. I do not work for Ripple; I am not a professional financial analyst, and the majority of my crypto holdings are XRP.

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