Moving on from the Middleman
By: Freddie Archibald
Tags: Decentralization, Satoshi Nakamoto, Cryptocurrency, Decentralized Exchange, Bitcoin

Moving on from the Middleman

The Disintermediation of the Digital Asset Capital Markets

In the interest of clarity, we consider the word “decentralized” interchangeable with “eliminating reliance on trusted third parties.”

Ever since Satoshi’s embedded message in Bitcoin’s genesis block, decentralized protocols have risen to address the failings of centralized systems. However, as the digital asset markets continue to mature, eerie similarities with traditional Wall St. are emerging. The space is rampant with trusted intermediaries facilitating value transfer between buyers and sellers. The result is a user base who instills their trust and reliance within a third party — the very principle that Satoshi wished to object.

The primary purpose of decentralized protocols is that they operate without a designated authority. Under this revolutionary model, economic incentives are employed to enable thousands of competing interests to achieve a common goal.

Side note: We don’t need to go into the profound merits of a decentralized ecosystem (Chris Dixon does an excellent job of that here, as does Vitalik Buterin here).

However the space is currently deviating from this vision. Immaturity of decentralized protocols and operational difficulties inherent in a nascent space have resulted in a brewing petri dish of middlemen. Perhaps the most obvious offenders are the intermediaries capitalizing off the bubbling capital markets environment, currently exemplified by exchanges and investment platforms. The centralized structure of entities such as Coinbase and other newcomers looking for a piece of the pie (most notably Robinhood, Circle Invest and Abra), is undermining the objective of the decentralized protocols they support.

Wall St. 2.0

Digital assets undertook a surge of popularity in 2017, entering the mainstream as millions in the U.S. market looked to gain exposure. While this frenzy has undoubtedly been net positive for the future prospects of decentralized applications, it has also demonstrated the burgeoning ecosystem’s increasing reliance on central parties.

Fueled by transaction fees and new projects paying a premium to be listed, exchanges are making as much as $3 million a day. Coinbase almost doubled their revenue estimates in 2017 hauling in over $1 billion while refusing outside investment. This is problematic as imposing high transaction fees for the exchange of digital assets is antithetical to Bitcoin’s model. A space seeking to create the opportunity for frictionless value transfer is fast becoming the opposite.

Beyond astronomical profits captured by exchanges, trust and security have also proven to be worrisome. Exchanges have a colorful history of hacks, dating back to the monumental breach of Mt Gox in 2014. This year alone, the asset class has seen $700 million stolen from exchanges (see here and here). As with any centralized system, having a single point of failure is a major security risk. The existence of such intermediaries also disregards another value of the digital asset space: privacy. Just like traditional financial institutions, Coinbase and its peers adhere to KYC laws, collecting extensive data on their users.

Of further concern, is the influence that these exchanges hold in the markets. The immense speculation and frenzy from Dec ’17 — Jan ’18 regarding assets that Coinbase was supposedly adding to its platform was unprecedented. Ripple’s digital asset, XRP, was touted to be top of the list, subsequently seeing it’s price increase 15x in three weeks.

XRP’s price fluctuation around Coinbase rumors

Unsurprisingly the price of XRP depreciated 75% in the two weeks following Coinbase’s announcement that it had no plans to add any assets. A similar trend occurred when Coinbase listed BCH and LTC, where we witnessed grossly speculative and irrational price movement. Just as central banks are able to influence the economy with monetary policy, Coinbase has similar market influence within the emerging digital asset market.

Movers and shakers?

The ecosystem’s increasing reliance upon centralized third parties is a byproduct of market fervour rather than ill-intentioned activity. And many of these companies have emerged to make genuine efforts to help the space innovate. Coinbase has just announced a Protocols Team to direct internal engineer horsepower towards community-led projects in the space. Other financial institutions/VCs are playing their part. Consensys is a notorious ethereum ecosystem builder and Blockchain Capital is launching Platypus Labs to provide fellowships and residencies for bitcoin developers. Of course, such endeavors offer mutual benefits to both parties. These entities are incentivized to create as much value as possible from decentralized protocols. For the likes of Coinbase and similar players, continuous innovation of protocols is crucial to their business model.

Side note: We remain optimistic and excited to see a protocol that figures out how to incentivize collective action to improve the protocol, without relying on centralized, permissioned financing.

Decentralized protocols require a deep and diverse breadth of users to operate a successful network. As cryptonetworks use tokens to incentivize network participants, networks need adopters and “owners” of the tokens to ensure networks are actually used once viable. Because of the operational barriers associated with buying bitcoin in a free market, the user experience offered by exchanges has accelerated token ownership for future network participants. Central entities and their leaders have also helped evangelize the space. Figureheads such as Brian Armstrong, Joseph Lubin and Jeremy Allaire have helped rally and inspire the troupe, and have been critical in working with regulators to further legitimization and acceptance. Central platforms have been essential in spearheading future network adoption by allowing and advocating for token ownership.

Why DEXes matter

Satoshi spurred Bitcoin’s development from 2008 through 2010 before stepping back to allow the community to spearhead its success. Similarly, to reduce reliance on third parties in the digital asset capital markets, the baton of influence must be passed back to the users of the network. An emergent solution may be the recent innovation of decentralized exchanges (DEXes).

DEXes eliminate the need to rely on an intermediary when executing a trade. They are decentralized marketplaces, where peer-to-peer transactions occur directly between the buyer and seller. This eliminates high transaction fees enacted by an intermediary and means that demand for a particular asset is driven almost exclusively by the buyers and sellers themselves. From a security standpoint, this model is revolutionary. DEXes do not control private keys and do not hold assets for trading. Custodianship risk lies with the user or the custodian they choose to entrust their assets to.

The concept of a DEX is not novel in this space. In theory, people should be able to buy and sell Bitcoin without having to interact through any intermediary (the function of the intermediary is replaced by cryptography and a distributed network of nodes). Armed with a computer and an internet connection, anyone should be able to participate in a free market. This was how the earliest Bitcoin adopters were transacting; peer-to-peer in its most genuine form. Although revolutionary, the free market structure is operationally onerous for the mainstream user. This opened the door for intermediaries to step in and offer a means to interact with the market.

DEXes are in the early stages of development, where there is currently a trade off between security and usability. The jury is out on whether there will be an uptake from the mainstream market. A positive and secure user experience will be crucial for users to leave the familiarity of Coinbase and other centralized exchanges. DEXes will have to overcome the 10x rule in order to lure users, where the upside of adopting new technology has to justify the pain of switching from incumbent technology.

Current players in the exchange space have recognized the need to diversify their offerings with a decentralized exchange. Bitfinex announced last month that it intends to launch Eosfinex, a DEX built on the EOS platform. Binance, citing the value of anonymity and security, is planning on introducing a DEX of its own, “Binance Chain,” to complement its current offering.

A sample of the multiple DEXes in operation and development

Side note: A comprehensive and mind-blowingly large list of all DEXes in the works can be found here

What of the future?

Ironically, the capital markets environment created from Bitcoin and its peers is riddled with financial institutions that are beginning to mirror traditional Wall St. Yet these trusted third parties have been essential in capitalizing the development of decentralized protocols, channeling profits and energy towards open-source projects that many will benefit from. As with the Dot Com bubble, irrational market frenzy and capital deployment can often spur increased technological innovation.

But the shortcomings associated with reliance on third parties remain. Just as Google and Facebook wield immense influence over the internet with their centralized bottlenecks of data capture, middlemen like Coinbase will continue to have disproportionate power within the ecosystem. There is risk of further consolidation as firms make opportunistic moves across the space — Circle’s acquisition of Poloniex being a recent example, with speculation of further M&A activity in 2018.

Decreasing reliance on trusted third parties will continue to be a rocky road. Decentralized exchanges represent the next step in the evolution towards a frictionless market. As the user experience of decentralized protocols improves and operational acumen matures, people may be less reliant on central exchanges and wallets for the exchange and custodianship of digital assets. We are excited about the many decentralized protocols emerging that seek to disrupt the capital markets ecosystem, with an eye on Satoshi’s original vision.

Disclaimer: The above references an opinion and is for informational purposes only. It is not intended to be financial or investment advice.

Thanks to Mack Delany for his contributions to this article.