Betting on decentralised exchanges (DEXs) and their role in the adoption of cryptocurrencies

Decentralised exchanges (DEXs) are exchanges where the user has control over his or her own funds, enabling trading in a trustless environment. Compared to a centralised exchange where the wallets are controlled and stored on the exchange, users connect their own cryptocurrency wallets addresses and interact with the smart contract with a DEX. This process automatically matches, verifies and executes trades without the need of a third-party. They address many of the issues that centralised exchanges currently face, namely single point of failure that if hacked or mismanaged, means that traders could lose their funds on a given exchange. In recent times, there have been numerous hacks (Zaif, Bithumb and Coinrail to name a few), delay or refusal to process transactions (Poloniex) and decision to suspend certain trading activity (OKEx’s decision to suspend the trading of BCH futures contracts by changing the settlement date and delivery). DEXs can also create global orderbooks and may operate across any country, an issue commonly faced by centralised exchanges (Coinbase).

Poloniex — Terms & Conditions that allows a centralised exchange to arbitrarily suspend your withdrawals

A decentralised exchange is built on the blockchain and allows for the peer to peer trading of tokens native to that blockchain. Traditionally, DEXs have been built on the Ethereum blockchain (Kyber, 0x Protocol, Airswap) however lately this has extended to other blockchains such as EOS or NEO.

While the decentralised exchange can be an individual product that’s not the only thing they’re capable of. Below are some of the functions DEXs play in the landscape.

Powering decentralised applications (dApps)

Decentralised applications will often require multiple tokens to operate them. You might require the native dApp token, Ethereum to send and confirm transactions on the blockchain, a storage token (Sia & Storj) to store the data for the dApp and perhaps a few other tokens depending on the specific needs of the project. The project might have these tokens to power the service on the backend, but it is unlikely that the users of these dApps will have such a portfolio of tokens (on top of having the correct ratios) to operate the application. The dApp can integrate with the DEX, which abstracts all of the tokens to the back end — allowing for a seamless user experience. Throughout this process, there is no third party API or account setup is required.

Kyber Swap allows users to swap ERC-20 token by connecting with their wallet of choice

A use case of this is Melonport’s integration with decentralised exchanges such as 0x, OasisDEX and Kyber Network. Melonport is trying to develop a decentralised asset management tool with the front-end operating on top of IPFS, while the back-end leverages off a set of Ethereum smart contracts.

In this scenario, the DEX functions as a liquidity provider for fund managers to directly tap into these pools when managing their portfolios. The ability to swap assets with one click is an incredibly convenient function for fund managers to instantly trade or hedge their investments.

Payment Gateways

To accept cryptocurrencies as a form of payment, merchants will likely need to rely on a third party to assist them with settlement (i.e from crypto to fiat) and hedging against price fluctuations. However, using a third-party completely undermines the purpose of cryptocurrencies as a decentralised form of transacting in addition introducing additional costs to the payment process.

DEXs can solve this issue by plugging into the backend of the payment gateway that facilitates the instant settlement of tokens. This premise is also predicated on the assumption that there are stablecoins on the DEXs, which most of the incumbents already have listed.

DAI is available quite a few decentralised exchanges… though the volume isn’t that high.

The process may look something as follows:

For instance, the merchant wishes to denominate the transactions in DAI. The customer pays for a coffee in OmiseGo (OMG), which then prompts the oracle to fetch the conversations for OMG <> DAI across the DEXs. The best rate is found and hypothetically, Airswap may settle that particular transaction.

This occurs without the intervention of a third party, namely a non-cash payment facility such as Visa or AMEX that may charge anywhere between a 2-3% fee per transaction. The case for transaction fraud is also eliminated — if you don’t have sufficient funds to settle a transaction, then it simply does not go through, rather than a merchant finding out that a purchase has bounced when the merchant attempt to settle the transaction after a few days.

Decentralised Pokemon!

A use case of this would be Etheremon’s integration with Kyber Network, one of the first dApps to integrate with Kyber’s onchain liquidity. As more dApps get created, so do the number of different cryptocurrencies — resulting in a more fragmented token ecosystem. Holders of cryptocurrenies are less likely to just hold traditional pairs such as BTC or ETH, but numerous other alt coins in their wallets. Meanwhile, most dApps usually only accept ETH and perhaps the games’ native token. The implication is that players need to exchange tokens they hold to Ether or games’ tokens every time they want to play, which may adversely affect the user’s experience when playing such a game.

In this scenario, the DEX functions as a swap service that allows its players to pay with any supported ERC20 token, such as Basic Attention (BAT), OmiseGo (OMG) or Zilliqa (ZIL). Simplifying the payment process into one step will allow users to seamlessly enjoy the game and more broadly, driving adoption for the entire dApps ecosystem.

Fundraising

Initial Exchange Offerings (IEO) have been proposed as means for fundraising for new projects. Developers mint the project’s tokens and send them to the DEX, who will then sell the tokens to individual contributors through their platform — creating a more accessible, usable and trustworthy platform for tokens sales. Token sales have traditionally only allowed for contribution of Ether, and potentially a few other coins (see Maidsafe token sale) to the smart contract. DEXs are aptly positioned to conduct IEOs as they are able to accept different token contributions. Users can contribute in the token of their choice (provided the contribution token is supported on the DEX), with the swap mechanism taking care of the rest of the process.

Issues surrounding DEXs

Despite all the advantages that DEXs offer, they are not without their own issues. A user must usually have cryptocurrencies already in order to access a DEX due to the lack of fiat onramps. Users must also manage their own funds with their own wallets and any other tools available to them. Thus, the barriers to entry for a DEX is quite high at the moment and immediately preclude the retail consumer from accessing them.

Interoperability

A key issue with DEXs to date has been the inability to facilitate liquidity across the decentralized ecosystem beyond Ethereum or the native blockchain a product is built on. The most prominent example is Bitcoin. Historically, there have been two key issues with Bitcoin and Ethereum:

This issue has prevented DEXs from unlocking largely amounts of liquidity traditionally generated by Bitcoin. At the moment, the majority of trading volume takes place on centralized exchanges with Bitcoin.

However, the collateralised token ecosystem on Ethereum now creates the possibility for bitcoin to be tokenised. Kyber Network and Republic Protocol recently lead a community project to put forward Wrapped Bitcoin Tokens (WBTC), an ERC20 token that is fully backed by real BTC and stored by regulated custodians. How WBTC works is that the collateral (BTC) is held on bitcoin chain and managed by trusted parties, while the Ethereum chain manages the distribution of the “proxy token” among token holders. WBTC would be treated as any other token on the DEX.

WBTC brings Bitcoin’s liquidity to DEXs, making it possible to use Bitcoin for token trades.

Whoa, an ERC-20 BTC? Yes please!

Additional issues for DEXs include:

  • Low transaction volumes. This is due to a combination of high barriers to entry for the retail consumer as well as elementary trading infrastructure for the more sophisticated audience to use such a platform
  • Shared scalability issues with their underlying blockchain. When the Ethereum network becomes bogged down, the time and gas costs required to execute a transaction becomes incredibly slow and costly
  • Failure of dApps adoption and small number of crypto owners that have wallets (most people have money in centralized exchange and use it as speculative investments) limits the usages of DEXs

What’s next?

DEXs will play a key role in the adoption of cryptocurrencies.

At the moment, they are very much in their infancy — DEXs are used by a niche audience and the technology behind them is still relatively nascent. However, the interest and merits of DEXs cannot be ignored. Radar Relay completed a $10 million Series A funding round in August. Airswap recently executed the world’s first security token transfer on a public blockchain with partners SPiCE VC and Securitize. The P2P compliant transfer of a security offers a significant innovation to the way in which traditional securities market operate, cluttered by intermediaries. And finally, centralised exchanges like Binance are considering their own DEXs despite their position as one of the leading exchange on the market. All that being said, it is important for the DEXs to consider the relevant compliance measures as platforms such as EtherDelta, which brand themselves as a “DEX”, have recently come under fire from the SEC for operating an unlicensed exchange.

As the adoption of cryptocurrencies increases and fiat becomes less relevant in the cryptocurrency exchange market, traders will likely shift from centralized platforms to decentralized exchanges, with the knowledge that counter-party risk will be eliminated. That being said, this will require the speed of processing and settling trades to be at millisecond levels, something that blockchains are currently incapable of. However, the ability to utilize non-custodial wallets to trade in a peer-to-peer manner with full control over your funds is an incredibly powerful function and resonates with the underlying philosophy of cryptoassets.

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David Lu

Chief janitor & fixer @DriftProtocol | Half a lawyer (not yours) | Hiring