In a previous life, I worked in the business side of the casino industry. Some considered me an expert. I wrote about it. I edited books and magazines about it. I advised regulators. I helped run online casino companies (in Asia and Europe, where it was legal) and consulted.
This was all before I got into bitcoin (some of my friends are still thanking me for that).
So why am I bringing all of this up? Because I worked in online gaming when it was a very young industry. And the exact same trends I saw there are starting to pop up in the crypto world.
The trend that caught my eye this week was decentralized exchanges. Coinbase recently acquired Paradex, a decentralized exchange for cryptocurrencies. Binance is launching a decentralized exchange for cryptocurrencies. And Decred is offering its own decentralized exchange proposal.
Decentralized exchanges differ from centralized exchanges (like Coinbase) in two critical ways:
- Users hold on to their own coins in wallets. In a centralized exchange, the exchange holds the coins to make buying and selling easier. This presents a huge target for hackers. If hackers can crack into an exchange, they can steal digital assets worth millions. That’s exactly what happened this week with Bithumb, an exchange in South Korea. But in a decentralized exchange, coins are stored in locations (and wallets) throughout the world, so hackers don’t have a single target to attack.
- Because subscribers of decentralized exchanges have direct access to their digital assets, this enables peer-to-peer (P2P) trading. This allows bitcoin owners to trade directly with each other without the exchange serving as a “middleman.”
And here’s where we get our history lesson.
The online gaming world tried decentralized betting exchanges about a decade ago. It didn’t work out as planned.
At the time, P2P online betting was thought of as a revolutionary concept. Instead of betting $100 on the Red Sox to beat the Yankees with a sportsbook, a punter (fancy word for bettor) could make the same wager directly with another punter. The bet cut out the middleman (everyone hates middlemen) and the platform skimmed a percentage off the top to generate revenue.
Sounds like a great idea, right? Everyone thought so at the time. But it didn’t really work.
The technology was lacking, compared to today’s vibrant blockchain innovation system.
And these P2P exchanges never generated enough users (liquidity) to create a sustainable business. Basically, sharks – who were really good at betting on sports and setting odds in their favor – would feast on minnows – casual bettors or betting novices. The sharks would win all of the money. The minnows would go away. And then there was nobody left to bet because the sharks didn’t want to bet against other sharks.
That’s exactly what decentralized exchanges need to guard against. In order for an exchange to work, it needs liquidity – people trading on the platform. But investors will only trade on a platform if they sense the price is fair. If investors feel like they’re getting ripped off, trading activity dies down, effectively bringing the exchange to a halt. It’s the classic chicken and egg problem.
These platforms also have to worry about arbitrage opportunities between their decentralized and centralized exchanges. Arbitrage is a great opportunity for investors. I know. I’ve done it before in bitcoin. (It’s amazing what you used to be able to do in China.)
But trading platforms don’t want to create those opportunities (especially if they’re operating under the same brand or parent company). It creates all sorts of activity that they’d rather not police.
These problems are not insurmountable. There are solutions – like pegging prices in some fashion to the centralized exchange and capping transaction costs. But decentralized exchanges need to tackle these problems early on. Fortunately, the technology has advanced by leaps and bounds since the gaming industry tried these “trustless” decentralized exchanges. And in crypto, much of the technology is open source, or free to use and change.
Still, we all learn by doing. That’s why I’m sharing with you the lessons the online gaming industry learned the hard way. I don’t think the crypto industry will repeat history and make the same mistakes. But I want you, our First Stage Investor, to know exactly what to look for as this market matures.
Decentralized exchanges are hugely important to the future of crypto, and we’ll be keeping a close eye on developments in this space.
Senior Managing Editor, First Stage Investor