Centralized Exchanges & User Account Freezing
Tags: Bitcoin, Ethereum, Exchange, Crypto, Insights

With over 99% of all crypto trading volume passing through centralized exchanges[1], they’ve come to be so ingrained within the cryptocurrency landscape that both existing and new users rarely think twice about using them. We’ve all seen the news and heard the warnings about storing tokens on centralized exchanges, but how many of us are actually willing to expend time and effort to use dedicated wallets and decentralized exchanges? Clearly, the answer is “not enough”: in 2018 alone, over $USD700 million[2] of crypto has been stolen by hackers in a series of attacks on centralized exchanges. Apart from security breaches, technical failures and general frustration with centralized exchanges: freezing legitimate user accounts, their kingmaking power and more — has led swathes of the blockchain community to concur with Vitalik’s much-quoted sentiment that “centralized exchanges go burn in hell”.

The community’s growing desire for change is fueling the development of decentralized exchanges (DEXs), a class of DApp that is slowly but surely rising to prominence. As the name suggests, they’re platforms or protocols that facilitate decentralized cryptocurrency trading, payment, swaps and other applications. Some of the benefits offered by DEXs are that users retain custody over their assets and personal information and are not limited by their geographical location.

Frozen

One issue that numerous users have faced while using centralized exchanges is their account being frozen with no warning, and it’s easy to imagine why that might be frustrating or even devastating in volatile or bear markets. And because centralized exchanges deal with huge customer volumes, dealing with frozen accounts through their helpdesks is often a slow and painful process. Let’s consider some clauses in the user agreement laid out by one of the current top exchanges by trading volume:

“You agree that we have the right to immediately suspend your account [and] your access if we suspect any such accounts to be in violation of the Terms of Service, Privacy Policy, AML/CTF acts or any applicable laws and regulations…the above account controls may also be applied in the following cases:

- The account is subject to a governmental proceeding, criminal investigation or other pending litigation

- We detect unusual activity in the account

- We detect unauthorized access to the account

- We are required to do so by a court order or command by a regulatory/government authority.

In the case of any of the following events, we shall have the right to directly terminate this agreement by cancelling your account, and shall have the right to permanently freeze (cancel) the authorizations of your account and withdraw the corresponding account thereof.”

From just this short excerpt, the irony of using highly centralized institutions (cryptocurrency exchanges) to trade fundamentally decentralized cryptocurrencies should be apparent. Centralized exchanges fully determine what constitutes “unusual activity” and “unauthorized access” and can unilaterally control your access to your account and tokens. We can also infer that they discriminate between users based on factors such as personal information provided and trading history, a clear case of user censorship.

At the same time, there are clear incentives for centralized exchanges to enforce compliance and take action to suspend user accounts even if it results in some user dissatisfaction. According to an exchange on track to be the first cryptocurrency exchange licensed as a regulated broker-dealer under the US Securities and Exchange Commission (SEC) and FINRA, it’s an “indication of the maturation of the crypto economy”. Given that this license will allow exchanges to facilitate the trading of cryptocurrencies even if they are classified as securities tokens, it’s not hard to see why centralized exchanges operate in such a way.

Should we let it go?

The phenomenon of user accounts being frozen echoes what first motivated Ethereum’s Vitalik Buterin to create his own blockchain platform — hilariously enough, it’s that Blizzard Entertainment modified one of the spells in World of Warcraft (which he then played), causing Vitalik to cry himself to sleep. Can there ever be an argument for centralized exchanges freezing user accounts?

Pros

Easiest option to manage risk of illegal transactions

Encourage the creation of a more comprehensive legal framework for blockchain and cryptocurrency regulation

Cons

Misaligned with the original purpose of cryptocurrencies

User accounts often wrongfully frozen, causing loss of personal property and assets

Allows centralized cryptocurrency exchanges to essentially act as banks and control the circulation of cryptocurrency. Forms single points of failure within the blockchain ecosystem.

It’s an open door

The real question is that with blockchain technology, are we able to fundamentally improve on the cryptocurrency exchange model? We now go full circle back to the topic of centralized and decentralized exchanges.

At the blockchain industry’s present stage it’s hard to refute that centralized exchanges provide valuable and in-demand services (managing private keys and providing a trading floor) in a convenient manner. They also serve as crypto-to-fiat gateways, which necessarily entail compliance with regulations. However, for crypto-to-crypto trades, DEXs allows users to retain full control over their funds and personal data. Furthermore, open standards being developed for the blockchain such as the R-Token Standard are poised to allow transparent compliance with KYC and AML policies, tax laws, securities regulations and more.

DEX alternatives such as EtherDelta, IDEX and DEx.top are quickly gaining popularity, but still, makeup just fractions of the industry’s total trading volume. Why? To answer this question, we need to look at the factors traders consider when choosing an exchange: while security is a priority, secondary considerations such as the order types and amount of leverage available, trading fees, liquidity and ease of use of the exchange often factor into a trader’s final choice.

While DEXs and dedicated wallets offer additional security over centralized exchanges, generally speaking the level of security provided by centralized exchanges is enough to satisfy most users. And when security is no longer a dealbreaker, the other factors previously mentioned such as advanced trading functions, liquidity and ease of use tend to weigh in favor of centralized exchanges. DEXs hold the advantage in terms of token availability (because it’s generally free to list on DEXs, small altcoins tend to list on DEXs first) as well as trading fees (though note that users will most likely also incur gas fees, which are dependent on Ethereum’s network traffic).

But if we consider the present situation, the security issues that plague centralized exchanges are inseparable from their core business model; they are able to provide such services precisely because they are custodial exchanges. In contrast, the factors that make DEXs less attractive currently such as their UI and trading functions are all solvable with advances in DEX technology. This makes a strong argument for DEXs eventually surpassing centralized exchanges — once the DEX user experience approaches that of centralized exchanges, users will naturally gravitate towards the superior security, token availability and trading fees they provide.

Market trends today are pointing towards increased decentralization across multiple industries and verticals. As DEX technology matures and adopts regulatory standards, it’s only logical that the future of cryptocurrency is decentralized exchanges.

Reference

[1] https://media.consensys.net/state-of-decentralized-exchanges-2018-276dad340c79

[2] https://rados.io/list-of-documented-exchange-hacks/

[3] https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:52016PC0450&from=EN

[4] https://en.bitcoin.it/wiki/Principles_of_Bitcoin