Overview of Decentralized Crypto Exchanges

What is a decentralized exchange?

First, let’s define a centralized exchange: one in which a third-party handles custody and order-books (think Coinbase, Bittrex, Poloniex, etc.) Liquidity pools are often proprietary to each exchange and depending on which jurisdiction the exchange resides in, relevant KYC/AML laws apply…

Decentralized exchanges can be defined as one where third-party trust/custody is cut out of the equation through the use of smart-contracts and protocol implementations. As many know, centralized crypto-exchanges are vulnerable to getting hacked (Mt.Gox, Shapeshift, Bitfinex); and at their very worst, implement shady practices (to go deep down that rabbit hole, follow Bitfinexed) The progression to decentralized exchanges can be viewed as a welcomed step towards self-securitization with the possibility of building a more efficient, cheaper, and trust-less exchange ecosystem.

Players in the space

While the pros of a decentralized exchange are vast, the infrastructure, functionality, and overall approach to building the ecosystem is widely debated. As such, many different protocols have emerged with varying strategies.

Below is an overview (not an exhaustive list) of some of these approaches…

0x

0x is an open, permission-less protocol facilitating ERC20 tokens to be traded on the Ethereum blockchain. 0x enables off-chain order-books to be settled on-chain. Additionally, relayers (which are essentially order-books that provide a front-end) broadcast 0x orders and collect a fee each time users execute a trade. Each trade using 0x must pay a fee using the ZRX token, which has a fixed supply of 1,000,000,000.

ELI5: 0x has built the back-end infrastructure for people to trade Ethereum tokens (ERC20). Other companies, such as Radar Relay, provide an easy-to-use interface where people can go and trade. On top of the ZRX fee per trade, relayers will charge a fee as well.

Token Mechanics: Like many tokens, the ZRX token is utilized to drive network effects and reward early adopters of the platform. Additionally, the token will be used for decentralized governance of the future development of the 0x protocol. While utility tokens with high velocity have been theorized to approach a future value of 0 (for more, check out Kyle Samani), it is fairly safe to assume that relayers will want to partake in the governance of the network. As a result, relayers are more likely to HODL their ZRX, increasing the value of the token over time.

ZRX vs. Relayer Value: In my opinion, relayers will be able to build profitable businesses (to varying degrees) on top of ZRX. First-movers such as Radar Relay surely have a head-start (1/9/18 volume was >$13M, mostly Radar Relay trading activity) and will be able to capitalize on this in the short-term. Over the long-term, though, relayer-fees have the possibility of becoming a race to the bottom, as there is a very low barrier to entry to participate in the 0x protocol. This low barrier to entry risk compounds if the norm of relayers becomes to share liquidity on the back-end, something which 0x enables.

Airswap

Airswap is a Consensys project that is building an ERC20 decentralized exchange most similar to 0x. The project is currently live on Ethereum’s test network. Airswap has more of a focus to cater to institutional market makers, as seen through their partnership with Mike Novogratz’s firm Galaxy.

Protocol specifics: From Airswap’s Deepa Sathaye

“AirSwap is a decentralized exchange platform that implements the Swap protocol, a peer-to-peer protocol for trading Ethereum-based (ERC20) tokens. AirSwap does not contain a traditional order book, but instead individuals solicit quotes from each other in a peer-to-peer fashion through off-chain negotiation. Counterparty discovery is done through an “indexer” component. The Indexer contains information regarding which token-pairs individuals would like to trade. Users are able to post and query the Indexer to find suitable counterparties.”

The key difference between Airswap and 0x is that Airswap trades are negotiated off-chain while makers/takers are mostly matched through relayers in 0x.

ELI5: If I am using Airswap, I will likely peruse indexers to find a trading partner. I will then negotiate with that partner and execute a trade using Airswap’s smart contract. If I am using 0x, I will use a relayer, which in conjunction with 0x, will automatically match me with a trading partner(s).

Token Mechanics: While Airswap had a token sale of AST, there was no mention of it in its whitepaper. One can assume it will have similar token mechanics to 0x, but it is unclear exactly how protocol governance will be administered.

Kyber Network

Kyber Network is an extremely ambitious decentralized exchange that aims to build payment railways for businesses through the use of a wallet, all on-chain. Kyber is not limited to ERC20 tokens, but aims to build a system that can automatically and seamlessly trade any token regardless of which blockchain it’s on. Kyber aims to provide automatic liquidity and pricing through the use of reserve warehouses (the first of which will be managed by Kyber). Over time, reserves can be added to the network.

One of the more interesting aspects of Kyber is its focus on consumer/enterprise adoption through the use of its wallet services. Since Kyber aims to provide instant and frictionless on-chain trading, consumers, in theory, will be able to pay a crypto-merchant in any currency while the merchant will be able to accept that payment in whichever currency she likes. For example, if a consumer wants to pay in XMR, but the merchant only accepts ETH, Kyber will enable the transaction to occur.

Token Mechanics: Kyber Network Crystals (KNC) are required for reserves to participate in the network and to reward various parties who will help generate increased trading activities on the platform. The collected KNC fees, after paying for operations and supporting partners, will continue to be burned over time. As a result of this deflation, KNC price, theoretically, will continue to rise as demand/usage grows.

On-Chain Risks: To put it simply: on-chain order-books, matching, and execution is not viable as the tech stands today (for an example of how simple dapps can crash a network, look no further than CryptoKitties). In theory, as projects such as sharding, Raiden, Plasma, Lightning, etc. continue to develop, on-chain scaling can possibly handle a project like Kyber.

Another aspect to consider is that Kyber aims to allow inter-chain trading. Projects such as Cosmos and Polkadot are working on solutions that would enable interoperability between chains, but again, Kyber’s potential hinges on the success of these projects.

OmiseGO

OmiseGO is similar to Kyber in that it is building a decentralized exchange that enables businesses and consumers to transact in the currency of their choice.

Through the OmiseGO network connected to the Ethereum mainnet, anyone will be able to conduct financial transactions such as payments, remittances, payroll deposit, B2B commerce, supply-chain finance, loyalty programs, asset management and trading, and other on-demand services. The OmiseGO Blockchain comprises a decentralized exchange, liquidity provider mechanism, clearinghouse messaging network, and asset-backed blockchain gateway.

Quick Thoughts:

• Repeat after me: “On-chain order-books are not viable today”
• Omise has roots as a payment provider in Southeast Asia, so has a leg up as it relates to on-boarding users/businesses. They recently partnered with McDonalds in Thailand, which is encouraging.
• The project is at best extremely ambitious which depends on many technological breakthroughs and at worst technologically unfeasible.

Etherdelta

Etherdelta was one of, if not the first, ERC20 exchange powered exclusively through smart contracts. It was created by Zack Coburn, who also founded FirstBlood.

Quick Thoughts:

• Etherdelta had great value for the community, but it’s domain recently got hacked, eroding user-trust
• The team is currently conducting an ICO, but the token does not seem to have any utility value whatsoever. Community sentiment is averse to the project.
• Etherdelta does not seem to have the long-term firepower to be a leader in the dex space.

While the case to build decentralized exchanges is clear, the “how” is not. From my perspective, off-chain/on-chain hybrid projects such as 0x have a leg-up on fully on-chain projects such as Kyber/OmiseGO. For one, 0x is live today, has an active community of developers building on it, and traders utilizing the protocol. Over time, if fully on-chain DEX projects become viable, it is quite possible that 0x, Airswap, or a competing decentralized exchange can upgrade the protocol as necessary.

From an investment perspective, the market, at some point, will stop responding to promises and memes and start consolidating capital behind projects which are reasonably achievable, have an active community, and most importantly, are shipping working products.