By Alexander Osipovich | Photographs by Victor Llorente for The Wall Street Journal
Coinbase Global Inc., which has made billions running cryptocurrency markets, is facing competition from a new breed of upstarts that look less like the New York Stock Exchange and more like Napster, the defunct music-sharing service.
Decentralized exchanges are peer-to-peer networks for swapping digital tokens. Last month, $122 billion in transactions took place on DEXes, as they are known, up from less than $1 billion a year earlier, according to data provider Messari.
Uniswap, the largest decentralized exchange, had volume of $36.6 billion in April, compared with $110 billion at Coinbase, Messari data show. Hayden Adams, a 27-year-old Brooklyn, N.Y., native, built the first version of Uniswap after being laid off from his job as an engineer at Siemens AG.
Unlike conventional crypto exchanges, DEXes don't require users to hand their digital tokens to the exchange to be able to trade. That appeals to traders worried about losing their holdings to hackers who have a long history of targeting crypto exchanges for theft.
There is no central authority on a decentralized exchange to decide who is allowed to trade, or what tokens can be traded. Uniswap can be used to trade more than 30,000 unique tokens.
"It's like eBay. If you want to sell something, you can list it," said Boris Wertz, founding partner of Version One Ventures, a venture-capital firm that invested in Uniswap last year alongside Andreessen Horowitz, one of Silicon Valley's most prominent VC firms.
Decentralized exchanges hark back to the initial vision of cryptocurrencies as a new type of financial system, free from middlemen. But some lawyers warn that DEXes could be on a collision course with regulators.
DEXes generally don't have safeguards against money laundering, or "know your customer" measures in which an exchange confirms the identity of traders using the platform. That could raise red flags for government authorities, especially as DEXes gain popularity, said Ashley Ebersole, a former Securities and Exchange Commission attorney.
"If a lot of money is moving across your platform, regulators could have serious problems if you're not asking even basic questions to know who's involved in those transactions and where they're located," said Mr. Ebersole, who is now a partner at Bryan Cave Leighton Paisner LLP.
There is evidence of criminals using decentralized exchanges. After the September theft of $281 million from KuCoin, an overseas crypto exchange, the thieves used Uniswap to trade $10.5 million of stolen coins for ether, a key step in their effort to launder the proceeds of the heist, according to Elliptic, a blockchain-analytics firm.
Another analytics firm, Chainalysis, has linked the KuCoin theft to a criminal syndicate working on behalf of the North Korean government.
Mr. Adams, the creator of Uniswap, said in an interview that he was "no fan" of hackers or scammers. But he stressed that Uniswap was simply a protocol -- a way for computers to talk to each other -- that could be used for good or evil.
"It is like the internet," he said. "There are good things that happen on the internet, and there are bad things that happen on the internet. The internet is this neutral infrastructure."
Moreover, because there isn't a central set of servers that runs Uniswap, it can't be shut down. It is also unclear how the government could require any entity to act as a gatekeeper and identity people using the protocol. Mr. Adams leads Uniswap Labs, a firm that has developed much of Uniswap, but his team has handed governance of the protocol to a broad community of users that can vote on policy changes.
Community members gain voting power based on their holdings of UNI, a digital token that was distributed by Uniswap's team last year. The total, fully diluted value of those tokens is about $24 billion, a number sometimes cited as Uniswap's valuation.
About 21% of UNI tokens were set aside for the Uniswap team, while an additional 18% were designated for investors. That means Mr. Adams and other current and future Uniswap Labs employees own a digital stash worth more than $5 billion at today's prices, although they can't tap it yet, due to a four-year vesting schedule.
Several years ago, Mr. Adams was jobless and living in his father's house outside New York. Having recently gotten into crypto, he started a project: building a decentralized exchange based on the Ethereum blockchain network.
Early DEXes struggled to provide good prices for their users because they didn't have a way to attract market makers -- firms that continually buy and sell financial assets, quoting prices that other market participants can trade against.
Mr. Adams's breakthrough, inspired by a blog post by Ethereum founder Vitalik Buterin, was to design a system of "automated market makers." These are computer programs that build up pools of tokens contributed by Uniswap users and determine prices using a mathematical formula, based on the supply of tokens in the pools.
In exchange for posting tokens into these pools, Uniswap users get a small percentage of the value of every trade, effectively letting them earn a yield for their crypto assets. More than 100,000 users are now acting as such "liquidity providers" on Uniswap.
It is unclear how much of a threat DEXes pose to centralized exchanges. One major limitation is that they can be used only for crypto-to-crypto trading, so investors seeking to swap dollars for digital currencies must use Coinbase or other conventional exchanges.
Still, the incumbents have taken note. Coinbase listed competition from decentralized platforms as a potential business risk before going public last month.
Mr. Adams predicted that major exchanges would eventually tap into Uniswap's liquidity pools, essentially becoming front-end interfaces with slick apps and websites that rely on Uniswap behind the scenes to power trading.
To some extent, that is already happening. Coinbase's wallet service, which lets people hold crypto assets, connects to Uniswap and other DEXes, allowing customers to buy coins unavailable on Coinbase's exchange.
There is room for both centralized and decentralized exchanges to grow, according to Coinbase Chief Product Officer Surojit Chatterjee. "Crypto isn't a zero-sum game," he said. "We see DEXes as a way to expand opportunities for our users."
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(END) Dow Jones Newswires