Flavors of ‘Bitcoin in Exchanges’ —From the Centralized to the Decentralized

Many cryptocurrency exchanges offer trading pairs in terms of Bitcoin (BTC): GDAX, Gemini, and Bitfinex are popular examples. When you are trading on these exchanges, the trades are fully centralized which means that there is liability. If the exchange is hacked then the coins in the hotwallets are lost. Furthermore, you aren’t trading BTC on-chain, you are only trading values in centralized databases (SQL typically) which are representative of balances and require trust. This is good but it is also the way that Mt.Gox worked.

Some forward-thinking minds created the systems used for ‘Bitshares’ and other exchanges, using OPEN.BTC and bitBTC as proxy ‘smart coins’ for Bitcoin. These act like Tether for Bitcoin: if you give me a proxy BTC coin (bitBTC), I will give you a BTC and vice versa. This means that the price is stable with BTC, and the proxy coin can have better attributes than BTC (onchain speed) while also being on a (different, perhaps less secure) decentralized network of its own. This is good but the on-ramps and off-ramps require trust and the proxy coins price does not always follow BTC’s price exactly, it can be somewhat illiquid and drift by 10–15%. In any case there are many different implementations of this same idea since it works marginally well.

Clearly, true atomic swaps with the real BTC blockchain would be fantastic, however, that is not a reality yet. We are probably many years away from realizing this technology and it may be simple or very complicated. Until then we must work on innovations we can accomplish at other angles.

The methods above describe ways to implement ‘BTC on exchanges’ in a more decentralized and scaleable way. Since traditional exchanges are disconnected from the blockchain and since the BTC network is not fast enough to perform all trades on-chain (without atomic swaps), our efforts have been fruitless. However, there is a blockchain network with exchanges running inside of it: Ethereum. Decentralized exchanges (DEXes) like ForkDelta are completely on-chain and all funds stay within pure transparent code-is-law smart contracts; no centralized databases or entities to trust. DEXes do not have Bitcoin (BTC) since it is, today, incompatible with Ethereum and atomic swaps as already described.

In the interim, there is another way to accomplish this using a more abstract approach. ‘Bitcoin’ as a technology and philosophical construct can be implemented inside of Ethereum from the beginning. An Ethereum token contract can be created such that it is pure PoW mined using a SHA3 hashing function and it can implement ERC20 so that it can be transferred similarly to ‘bitcoin’. Since the token runs on Ethereum, pure decentralized exchanges and even hybrid-decentralized exchanges can use this ‘bitcoin’ proxy currency in a completely decentralized on-chain manner. It behaves and technologically is nearly identical to BTC including mint time targetting and halvenings. This token, although not tied with BTCs price or today’s mining schedule, can be traded on exchanges and used within software without requiring the use of any centralized database; these actions can be performed on-chain, especially as the Ethereum network increases in scale and bandwidth.

Of course this is not a replacement for BTC today, but is strictly a better ‘proxy token’ than bitBTC and similar constructs for the Ethereum network. The more wonderful aspects: This token’s governance and control will be totally decentralized with no ‘owner’ or ‘monarch’ just like BTC. Pool mining can be easily accomplished, and as ERC20 tokens have more software frameworks and tools, so will this token. Truly, this token’s purpose would be for anything that anyone wants: do with it what you will, it is permissionless. It has new advantages and could be constructed with a little bit more hindsight. It is pure mined, so that means its distribution would be community-driven and bitcoin-like, and it helps solve a real problem that all exchanges face. It is a new technology for Ethereum and cryptocurrency exchanges. Please share your thoughts.