FROM.P2P-TRADING.TO.CRYPTOCURRENCY.EXCHANGES

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For this article, we will focus on the origin of cryptocurrency exchanges, and the trade-off between decentralized and centralized value exchange. But be aware, this article is merely a broad outline, which summarizes the rich history of cryptocurrency exchanges.

Context

The way we purchase cryptocurrencies changed drastically over the years. From Satoshi’s whitepaper, we understand his appeal of how bitcoin should be exchanged peer-to-peer — avoiding decentralized actors handling as the middleman. We should not forget that the elimination of the middleman, in response to the financial crisis of 2008, was one of the decisive features of bitcoin to prevent centralized actors from gaining power over the network, the supply, and ultimately the end users.

Yet, much has changed since the first bitcoin block was mined back in 2009. First, p2p-trading looks good on paper, and all transactions are still executed through the p2p-network. But during the early days of the network, people were expected to exchange bitcoin by solely using the p2p-network. There wasn’t an exchange that connected buyers and sellers, and therefore, those who were looking to buy or sell bitcoin, were obligated to find a counterparty on forums like Bitcointalk. So, in order to buy or sell bitcoin, you first had to find a counterparty, and arrange a deal based on trust. Eventually, the trade would be settled over two different payment layer. The fiat currency would be transferred via intermediaries like PayPal, and the bitcoin(s) would be transferred over the bitcoin network. Trust between parties was crucial because the early transactions couldn’t be settled through one payment layer.[1] [4]

Transacting over two payment layers (the fiat network and the bitcoin network) required trust from both parties , and therefore, created the ideal mix for scams and malicious activities. So, it didn’t take too long for third parties to see the appeal of developing exchanges to trade bitcoin, which would eliminate the trust factor, by automatically matching both selling and buying parties (see the figure below, presenting the two payment layers).

Transaction settled over two payment layers

First steps

Ten months after the first bitcoin block was mined, the first initiative towards an exchange was launched in October 2009, named The Liberty Standard. Besides developing an exchange to trade bitcoin for fiat (or vice versa), they determined the first exchange rate, based on the cost of electricity to mine bitcoin. The calculation went as followed: $1.00 would be divided by the average amount of electricity required to power a CPU strong enough to mine bitcoin, multiplied by the average residential electricity cost in the U.S., divided by 12 months, and lastly, divided by the number of bitcoins mined on his computer the past 30 days.[6]

The lengthy formula would set the first price of bitcoin, $1.00 would be equal to 1,309.03 bitcoin. To briefly sketch the exponential price growth of the network, that 1,309.03 would be worth over $52 million, which seems ridiculous from a 2022 perspective. But we need to consider that most people who bought bitcoin at those low rates, either spent it, lost their keys or sold it over the years.

So, the first bitcoin exchange rate was set, based on the required work to mine bitcoin, and therefore, the early fluctuations would be dependent on the input of the formula (i.e., pricing of electricity, upgrading CPUs when the mining competition increases, etc.). Yet, the trading experience of the platform was rather primitive and still required trust. Those willing to buy or sell bitcoin, needed to send an email requesting the number of bitcoin they would like to buy or sell. Then a deal would be arranged, and the bitcoin would be sent over the p2p-network, and the fiat settlements were transferred via PayPal.[4] [6]

The ramp up

It didn’t take long for others to see the ocean of opportunity, and starting in 2010, numerous bitcoin exchanges launched without any strict regulations. The first ‘major’ platform that would connect buyers and sellers was the Bitcoin market (TBM), founded in February 2010. On TBM, users could credit their account with dollars through PayPal, and therefore, easily buy bitcoin on the exchange. Also, it made it possible for bitcoin holders to liquidate their assets and transfer their earnings to PayPal. Yet, it didn’t take too long before scammers found their way to the platform, and thereby, from 2011 PayPal decided to stop offering support on the platform.[1] [5]

Traditional exchange model

TBM’s great success, caused a boom of new trading platforms competing for users to trade bitcoin. It was a new era of sketchy platforms, vulnerable to hacks, exploits, and scams. Even though most of these platforms are long forgotten, one infamous platform still holds relevance to this day, named Mt. Gox. The exchange was widely successful between 2011–2014, and handled most of bitcoin’s trading volume (70–80%) during its prime time. Yet, the exchange wasn’t spared from hackers and malicious activities, and in short, Mt. Gox eventually lost between 650,000–850,000 bitcoin from its users (but around 200,000 were recovered). Eventually, In 2021,a glimpse of hope was given to the victims that filed a claim against Mt. Gox, and potentially around 140,000 bitcoin could be handed back to victims.[2] [3]

The acceleration of crypto exchanges and the lack of regulation, has been considered as the wild west era of the cryptocurrency industry. But over the years much has changed within the industry, leading to the flagship exchanges we use today.

Current practices

We take a big leap from the 2011ish era to our current timeline. Thereby, we skipped the Ethereum and ERC-20 token ICO boom (and bust) that gave us exchanges such as Binance.

If we look at the current market structure of cryptocurrency exchanges, we identify several major players like Coinbase, Kraken, Gemini, and FTX that fought their way to the top. Each platform used different strategies — offering certain coins/tokens, trading features, competitive trading fees, and more. Yet, the major platforms didn’t eliminate the need for smaller and local orientated exchanges, which mostly offer additional benefits for local users (i.e., easier registration, instant bank transfers, etc.).

Timeline of major cryptocurrency exchanges

The present market structure is the result of the crypto-space slowly gaining maturity over the years. Features such as Know Your Customer (KYC) made the exchange of cryptocurrencies more transparent and accessible for the masses. Still, p2p-trading is still possible, and therefore, no one can stop users to transfer cryptocurrencies directly wallet-to-wallet.

Conclusion

Satoshi’s vision was to build a monetary network that would function without any intermediaries. This is still possible, the network is built to solely depend on p2p-trading, but ultimately, we still find ourselves using centralized exchanges to buy, sell, and store our crypto assets.

The question we should ask ourselves is: can we truly avoid centralized institutions to settle financial transactions? Relying on p2p-transactions requires enormous trust between the transacting parties, and non-regulated platforms are too vulnerable for malicious activities. So, what alternative can we provide for users in order to create a secure trading environment, and offering the regulated authorities (i.e., tax authorities) insights in the platforms’ practices.

How we trade cryptocurrencies is almost identical compared to traditional stocks, where we rely on intermediaries to register our trades. Essentially, we as the community debunked Satoshi’s perspective of decentralized value exchange, and most traders fully depend on centralized exchanges. Again, we (and partially myself) rely on the trustworthiness of centralized actors to create a safe trading environment, and the ability to store cryptocurrencies (for those who store their funds on an exchange). Still, exchanges have already proven themselves vulnerable to hacks and exploits. Thereby, even major exchanges have fallen victim to hacks and exploits, which resulted in users’ wallets being emptied.

Still, we didn’t discuss the potential solution that could offer the benefits of a traditional exchange without the centralized nature. Decentralized exchanges (DEX) operate without a centralized intermediary, and trade via smart contracts between the users. It offers users the sovereignty over their crypto assets and financial privacy. Yet, due to the limited intervention capabilities and (almost) no ability to monitor these exchanges, regulators are weary about the growing interest of decentralized exchanges. But if regulations regarding cryptocurrencies would increase, we can assume an exponential growth in users, willing to transact over decentralized exchanges.

This article gives a brief overview of the exchanges. We could have explored the numerous possibilities of decentralized exchanges further, but this would extend the article a few thousand words. Therefore, I’ll publish an article solely about DEXs. For more information, please consult the sources or use Google and get lost in the rabbit hole.

[1] Collins, Clay. “A History Of Crypto Exchanges: A Look At Our Industry’s Most Powerful Institutions.” Nomics (blog), November 14, 2019. https://nomics.com/blog/essays/crypto-exchanges-history#pre-history.

[2] Franjkovic, Teuta. “Mt Gox Rehab Plan of Returning 141,686 BTC Gets Approved.” Yahoo Finance (blog), November 17, 2021. https://finance.yahoo.com/news/mt-gox-rehab-plan-returning-152305328.html?guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAFoSHNNfVNcau8Z5yla6ZDhpQDed6BL4yJNCUfEvG0CQ_SrCoUR6exdRTtGH9YLNzua3sgpmGUZCIqgotTj3qEZUbUzauTEd67XjTI_w4nCctd88kBwc4eRulnjVVkVXG0Po7bxj-3RZdZY86jgoLvQJMZyOWD2Nm7Wnp-OwxIIH&_guc_consent_skip=1645474134.

[3] Frankenfield, Jake, and Erika Rasure. “Mt. Gox.” Investopedia (blog), January 13, 2022. https://www.investopedia.com/terms/m/mt-gox.asp.

[4] “History of Bitcoin Exchanges and Trading.” bit2me (blog), n.d.

[5] Luther, William J. “Getting off the Ground: The Case of Bitcoin.” Journal of Institutional Economics 15, no. 2 (2018): 189–205. https://doi.org/10.1017/s1744137418000243.

[6] Marques, Bruno. “New Liberty Standard Twelve Years Ago, Sold 1300 Bitcoin for 1 Dollar.” Crypto Definance (blog), October 5, 2021. https://www.cryptodefinance.com/1300btc-worth-1dollar-new-liberty-standard/.