Evaluating the Rise of Decentralized Exchange, Pt. 1
This is the first piece in a two-part Evaluating the Value and Rise of Decentralized Exchange; click here for part two. This document is a personal investment analysis of highly risky assets and should not be considered investment advice. The document had feedback and edits from Derek Hsue and Dillon Chen.
One of the most promising use-cases for blockchain in the immediate future is decentralized exchange (DEX). This is a result of blockchain’s inherent technological value in tracking assets in a decentralized manner and its ability to solve the current problems with centralized exchanges for retail investors.
Due to the value of DEXs, it is likely that they will manage about 1–4% of market trading volume within the next 2 years. Since volume is currently around 0.2% of the total market, we expect these protocols to experience 5–20x growth over the next two years, assuming no growth in market volume and a long-term correlation between project usage and token price.
Throughout this two-part analysis, we cover:
Part 1
- Requirements for any kind of exchange
- Problems with centralized exchange
- Benefits of decentralized exchange
- Potential problems facing decentralized exchange
Part 2
- Top projects in the space
- Current industry bottlenecks
- Market thesis
Requirements for an Exchange
In order to structure an evaluation of the differences between decentralized and centralized exchanges, it is important to consider the requirements for any kind of exchange.
1. Large Network of Buyers and Sellers: For an exchange to function properly, there needs to be a large number of buyers and sellers to prevent market manipulation, ensure accurate pricing, and allow liquidity.
2. One or Few Pricing Pairs: While offering multiple pricing pairs can provide flexibility for investors, it means assets will have different prices depending on the currency used to purchase. This opens markets up to arbitrage, which is detrimental to investors.
3. Low User Fees: If fees are not reasonably low, users will be required to trade substantial levels of capital in order to offset the costs of investing. This reduces profits for most investors and also establishes a sizable barrier of entry for individuals to engage in investing.
4. Quick Transaction Speeds: Users need to be able to place a transaction, have it go through, and receive the money back in their accounts all in as little time as possible. This time is affected by the speed of executing a transaction and the speed of moving assets between accounts.
5. Simple and Effective User Interface: Different types of investors will have different requirements for their exchange user interface. Average Joe will likely want to be able to make a transaction as quickly and easily as possible, while someone from Wall Street will want access to more information and analysis. In either case, the exchange’s interface greatly dictates the experience and success of its users.
6. Scalable Technology: Finally, it is crucial for exchanges to be able to handle maximum levels of trading activity. When volume spikes, the exchange still needs to be able to process transactions, rather than shut down.
Problems with Centralized Exchange
High Costs: A centralized exchange inherently has higher costs due to larger staffing, profit, overhead, and security requirements. These costs get passed on to consumers via higher transaction fees. One possible solution includes trade-mining, where exchanges utilize a native exchange token for fees and reimburse users through proportional redistribution; collecting profits through token value appreciation via increased demand.
Security/Hacking: Centralized exchanges must hold all of their consumers’ assets in a centralized server, making centralized exchanges prime candidates for hacking. Incidents such as with Mt. Gox and CoinCheck have highlighted that digital asset exchanges, in particular, are prone to security concerns.
Order Arbitrage: One of the largest issues with centralized exchanges is that they see the incoming and outgoing orders. They are able to abuse this information to “run in front” of orders and make quick gains (a practice called frontrunning). Additionally, they can delay crediting orders during price movements in order to capitalize on price spreads.
Transaction Scaling: During late December and early January, crypto exchanges were receiving upwards of 250,000 signups per day and would see 40x increases in volume during trading spikes. Since exchanges have centralized computing power, these strains on their software led to routine exchange shutdowns and delayed transactions.
Advantages of Decentralized Exchange
Increased Security: With decentralized exchanges, you never hand over control of your assets to a third-party. This allows individuals to personally protect their assets and drastically reduces the odds of a hack, since there is not one centralized asset account.
Lower Fees: Due to lower overhead requirements, users benefit from lower transaction fees. However, while the blockchain ecosystem is being built out and blockchain congestion remains a concern, fees for decentralized and centralized exchanges are comparable in some cases due to heightened gas prices. (Based on data from etherscan.io and public fee structures for centralized exchanges.)
Easier Asset Management: Investors hold their own assets in a decentralized exchange, rather than having to pass their assets to an exchange for custody. This allows users to make a trade then immediately turn around and use them for purchasing a product, paying a friend, or making a transaction on a different exchange. Whereas centralized exchanges like Robinhood and Coinbase have time delays between deposits and withdrawals lasting several business days (see table above).
E-Commerce Payment Flexibility: Via decentralized exchange, a user can purchase an item with their crypto wallet and the merchant receives the payment in their desired token.
Problems Facing Decentralized Exchange
Frontrunning: Decentralized exchanges still need some mechanism (whether third-party or code) to match buyers and sellers. There needs to be a trustless mechanism to prevent a third-party from looking at unconfirmed orders and undercutting them to make easy profits. One possible solution 0x is exploring is a semi-decentralized trade execution coordinator.
Fragmented Markets: Since decentralized exchanges typically aim to have less structure and more freedom, buyers and sellers will be more fragmented and network effects will be less beneficial for growth rates. Separating markets into too many pricing pairs with different exchange rates and liquidity pools would magnify this. This could affect Kyber, OmiseGO, and Bancor’s liquidity network approaches.
Also, if projects on the same DEX protocol have their own siloed sets of buyers and sellers (as with 0x and their “relayers”), total protocol growth would likely be slower. 0x is currently attempting to have relayers share liquidity via an API, but it is uncertain if a significant portion of the relayers will adopt it.
For reference, NASDAQ and NYSE markets see respective daily trading volumes of $130.6 billion and $55.3 billion, while Binance (the 3rd largest cryptocurrency exchange) experiences daily trading volume of $1.4 billion, and the total DEX sector has daily trading volume of roughly $25 million. (Trade volume statistics from nasdaqtrader.com, nyxdata.com, and coinmarketcap.com as of 8/1/18.)
Atomic Swaps: Partly due to technological constraints of the blockchain, decentralized exchanges need to build out atomic swaps that switch a buyer and seller’s assets cross-chain when their orders have the exact same preferences. This lowers fees and increases transaction speeds. Many of the decentralized exchanges are developing and testing this technology currently, as interoperability has become a major emphasis.
KYC/AML: As the SEC begins to regulate the crypto industry, the most logical point of regulation comes down on exchanges, requiring tracking of who enters the space and how much their holdings are. Exchanges in the space will need to get better at conducting KYC/AML. For decentralized exchanges, this will likely involve a protocol layer that verifies user identity before allowing them to join the exchange and blacklisting addresses for bad actors or non-accredited investors when applicable.
# of Exchange Rates: Exchanges are currently attempting to figure out how to allow users to exchange any token for another without needing to first sell a token for BTC and then use BTC to buy the other token. Requiring sale to BTC can delay transaction speed and increase fees, while allowing direct sale between all tokens would create too many pricing pairs to be an efficient exchange. Bancor Network is solving this with “smart tokens,” which offer market liquidity for any token with a single price in USD. This is made possible via a number of smart contracts that store market liquidity and allow users to move from one token to another.
Trade Collisions: The blockchain functions by grouping transactions into “blocks” and processing them. For many protocols, this occurs about every 5–10 seconds. If two individuals submit the exact same order within 5–10 seconds of each other, the transactions would enter the same block, both users would have to pay transaction fees, but only one of the transactions would go through. This is called a trade collision and as the size of markets increases, without a solution, this will occur more frequently and result in higher fees for users. There are a few approaches for DEXs to limit or prevent trade collisions that we will explore in Part 2, along with analyses on specific DEX projects and our personal investment outlook.
