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The Future of Bitcoin Exchanges

Published on February 20th, 2014 by Let's Talk Bitcoin!
By Richard Myers

Regulation begets Centralization

The recent news from Russia, China and India are good reminders that Bitcoin exchanges are vulnerable to state intervention at the points where they must interact with regulated financial institutions like banks.  The specific regulations that would legitimize the Bitcoin payment network have not been adopted in most jurisdictions and this has led to tenuous relationships between Bitcoin exchanges and their banks.  Some regulatory delay can be attributed to a lack of understanding by regulators and some to the relatively small size of the Bitcoin market.  Caution by banks and regulators may also come from the existential threat Bitcoin poses to traditional banking generally.

Nonetheless, in most liberal democracies new regulations are evolving and most exchanges have taken preemptive steps to comply with relevant existing rules.  In particular, most exchanges have adopted financial reporting and “know-your-customer” (KYC) rules currently applied to financial services businesses in an effort to prevent money laundering, the financing of terrorism and tax evasion.  Bitcoin exchanges will also undoubtedly be expected to follow rules that support currency controls in countries where such controls exist.   Even before being finalized, efforts to comply with potential regulations have favored large well financed organizations able to hire the consultants and staff required to implement these rules.  As time goes on, ever increasing regulatory burdens will form even greater barriers to entry for new exchanges.  The expected result will be a small number of large exchanges able to comply with whatever regulations are mandated in the currency jurisdictions they operate in, and who are easily closed down for any failures to comply.

Centralization and its Discontents

Centralized and regulated Bitcoin exchanges such as BTC-e, Bitstamp and Mt. Gox all have business models similar to traditional financial services enterprises.  They take deposits of government currency which they hold in company controlled bank accounts and show as a credit in the customer’s exchange account hosted on their corporate servers.  Bitcoin deposits are also stored and managed on corporate controlled servers.  This model is vulnerable to both theft of deposits and identity theft.  These risks can come from employee error or malfeasance as well as from internet hacking.  Legal attacks both civil and criminal can also put deposits and privacy at risk.  Traders using centralized exchanges also have little ability to protect against insiders front running trades and online denial-of-service attacks during times of high market volatility.  These are not just theoretical risks, most have already been experienced by Bitcoin exchanges past and present.  The recent technical problems at Mt. Gox also highlight the additional risk that can come from proprietary implementations of the Bitcoin protocol.

The centralized model is an expedient and profitable way to run a Bitcoin exchange, but regulation will prevent this type of business from realizing the most useful features of Bitcoin. International payments and remittances are an important application for bitcoins.  In developing countries, where payment alternatives are most needed, regulatory costs and graft will work to increase fees on centralized exchanges and diminish or eliminate Bitcoin's theoretical cost advantage over Western Union and other established players.  The ability of people to use bitcoins to preserve purchasing power in countries with currency controls is another essential feature of the Bitcoin payment network, yet centralized Bitcoin exchanges will be forced to adhere to the same currency control rules now enforced for banks.

Bitcoin transactions are irreversible by design, but an exchange operating within a strict regulatory framework could be asked to enforce consumer protection requirements such as Regulation E of the Electronic Fund Transfer Act in the United States which provides for chargebacks when using a debit card.  Online merchants would lose an important reason to accept bitcoins if regulated exchanges are used to enforce chargeback rules.  Increased regulation also adds compliance overhead that will bring transaction fees closer to that of bank based payment methods.

Apart from the regulatory risks, centralized exchanges are also risky places to hold bitcoins on account.   Like cash, bitcoins are bearer instruments that can be redeemed anonymously.  Banks and other traditional financial institutions hold very little actual cash on hand and are insured against any thefts of government currency. Bitcoins, though, can and have been stolen by internet thieves in large quantities and not recovered.  Best practices for protecting bitcoins held in trust from theft are still evolving.  The risk can be mitigated with cold storage, client side encryption, 2-factor identification and multisignature techniques, but as online bitcoin wallets grow in value, the incentive to hack them also grows.  Whether through technological failure, insider subversion or organizational bankruptcy, bitcoins held on account at a centralized exchange are a target for hackers and at higher risk than a well managed local bitcoin wallet running peer reviewed software.

As an example of what can happen, the large retailer Target in the United States recently had 70 million customer’s personal information stolen, including credit and debit card numbers, despite industrial strength security.  Unlike credit card numbers that sell on the black market for as little as 0.25 USD each, stolen bitcoins can be redeemed at par.

Decentralized Exchanges

The answer to the problems of centralized Bitcoin exchanges is to use decentralized exchanges that take advantage of the decentralized nature of the Bitcoin protocol.

The essential characteristic of a decentralized exchange is that bitcoins and government currency are exchanged directly person-to-person with the optional arbitration of a third party when disputes arise.  Rather than a few centralized exchanges that a government can easily monitor and shut down for not following capital controls or chargeback rules, any two people wishing to exchange bitcoins for government money can do so directly with the right tools.   One example of such an exchange is an open outcry event where people exchange cash for bitcoins in person such as Satoshi Square in New York.  The Finnish company LocalBitcoins.com facilitates in-person and online exchanges of bitcoins between individuals all over the world.  The new company Purse.io facilitates the exchange of dollars for bitcoins between people via the purchase of online goods from Amazon.com. These solutions currently lack the liquidity of the large centralized exchanges, but can have lower fees and easier registration for new users who are often reluctant to share with an exchange the kind of personal information required to satisfy KYC rules.  Person-to-person bitcoin exchanges can also offer faster settlement directly between bank accounts (or in cash) whereas centralized exchanges often impose delays when cashing out or adding funds; especially during episodes of high market volatility.

Distributed exchanges do however have their own unique challenges.  Most people are reluctant to meet in person to exchange money, and online person-to-person transactions suffer from counterparty settlement risks. While it is possible to escrow bitcoins with a third party via the Bitcoin protocol, receiving government currency online carries risks.  The biggest risk is the payment being reversed by a fraudulent counterparty who has hacked into someones bank account and is trying to launder the money into bitcoins.   Such a person buys bitcoins with money from an account they are not authorized to use and when the unauthorized access is discovered the bank will try to reclaim the stolen money that has now been used to buy bitcoins. In other situations, the buyer of bitcoins may fraudulently claim unauthorized access to their account and try to reverse the transaction to get their money back for the bitcoins they have received.   Most counterparty settlement risk can be mitigated with reputation systems and escrow services and distributed exchanges are evolving to deal with these challenges.  The LocalBitcoins.com site, for example, categorizes payment methods as low, medium or high risk based on the ability of a counterparty to reverse the transaction.  The much publicized Silk Road site offered a reputation system, similar to EBay, that enforced honest dealing from vendors paid in bitcoins.

Sites like LocalBitcoins.com reduces the regulatory issues of centralized exchanges, but still suffer from being a central entity that can be targeted for government enforcement actions and online theft..

The Bitrated.com project is an example of a more fully decentralized Bitcoin escrow system that allows people to exchange goods or currency with the help of an arbitrary third party acting to escrow the bitcoin side of the transaction in such a way that the escrow agent can not independently spend or lose the bitcoins.  This is possible because the Bitcoin network supports creating accounts (using p2sh addresses) that automatically require at least two of three signatures to release escrowed funds.  During a successful exchange when the side receiving government currency receives the money in their bank account, they then release their escrowed bitcoins without needing the escrow agent to be involved to sign the transaction.  But if they do not receive the money, or if they claim to have not received the money and did, the third party escrow can adjudicate the dispute and needs only one of the other parties to sign the transaction to refund or disburse the bitcoins.  In this system anyone can act as a third party escrow agent as long as they are trusted by the counterparties to fairly adjudicate disputes. There is no single centralized person or website that can be closed down or stolen from and the escrow agent can not lose or steal the bitcoins being escrowed independently of the two parties trading.

Even the most totalitarian governments will find it difficult to effectively restrict citizens from privately exchanging small amounts of bitcoins for government money without creating rules that would stifle all types of informal economic activity.   The future of Bitcoin will be shaped by the emerging protocols and tools that facilitate Bitcoin markets as decentralized as Bitcoin itself.

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