Evaluating the Rise of Decentralized Exchange, Pt. 2

This is the second piece in a two-part analysis, Evaluating the Value and Rise of Decentralized Exchange; click here for part one. This document is a personal investment analysis of highly risky assets and should not be considered investment advice. The document was written by George Beall and Phil Levens with feedback and edits from Derek Hsue, Dillon Chen, and Lynne Ji.

In part one, we covered exchange requirements, problems with centralized exchange, and the benefits and potential problems of decentralized exchange. This second part will cover:

  • Top projects in the space
  • Current industry bottlenecks
  • Our market outlook

Top Existing Projects

There are a number of different projects currently tackling the decentralized exchange use-case; the following are the largest and/or most promising.

Technical development for top decentralized exchanges

0x (ZRX)

0x approaches decentralized exchange by offering a protocol for other exchanges, or as they refer to them, “relayers.” This protocol allows a relayer to conduct the order matching between a “maker” and a “taker” without the relayer ever needing to control the assets. They phrase this as “off-chain order relay with on-chain settlement.”

This project is among the most developed of the different decentralized exchange projects. It launched in 2017 and currently has 16 different deployed relayers built on its protocol. These relayers conduct over $2M in trades per day with more than 100,000 trades having been conducted. Recently, major exchange Coinbase acquired Paradex, a 0x-based decentralized exchange platform, attesting to the immediate value these projects can offer.

One of the perks of 0x is that they are a fairly minimal protocol that allows adaptability, and the team has a strong track record for developing and adding functionality to the project. This helps investors get a clear picture of their development roadmap and trust that they can achieve each objective. Their roadmap additionally displays an understanding of the major problems facing the industry right now and offers reasonable solutions for overcoming them.

Among their developments, 0x has developed a protocol for encrypting and trading ERC-721 assets, which are non-fungible assets (i.e. Cryptokitties, which are all unique). The team is adding functionality for a relayer API that would allow relayers to share market liquidity, a browser plug-in that helps users purchase crypto via the 0x exchange, exchange filters to help with KYC/AML and blacklisting bad actors, and a time encryption to prevent frontrunning.

Bancor Network (BNT)

Bancor Network utilizes a decentralized system with a “smart token” that serves as a conversion pair for all tokens. This system allows for increased market liquidity, one pricing pair, and instant transactions. There are no order books, but rather the Bancor Formula stores sell orders in smart contracts, which are used to fulfill later sell orders. There are no fees except for the blockchain’s required gas.

Bancor does not charge any added fees to consumers and has also worked to create optimized code which can reduce Ethereum gas fees. During major network congestion in early 2018, Bancor deployed code that reduced fees by over 80% for users. They have also created a solution for front-running by utilizing a cryptographic time signature, similar to 0x’s described design. Additionally, their exchange has over 100 tokens listed and is an EOS partner.

While there are a variety of beneficial qualities to Bancor as an exchange, such as instant liquidity, low fees, high-quality user interface, etc. there was recently a hacking incident where malicious users hacked a few of Bancor’s liquidity smart contracts and stole millions in assets. This incident undermines both the quality of the technology and Bancor’s brand, resulting in justifiable decreases in usage.

DEXs are only more secure than centralized exchange if they are securely set-up and therefore attention to protocol quality and infrastructure is crucial. Any hacking event with a DEX resulting in consumer loss ought to serve as a major negative indicator for product value.

Kyber Network (KNC)

Kyber Network’s decentralized exchange ecosystem operates on a system of reserve pools rather than order books. Reserve pools are paired with smart-contracts specifying appropriate exchange rates, which allow exchanges to be completed instantly with no fees beyond the blockchain’s required gas.

In early June 2018, Kyber announced a brand pivot at their Kyber 2.0 event, unveiling their plan to become “the decentralized liquidity network for the tokenized world.” By leveraging their trustless liquidity pool system and utilizing 4 new platform interfaces (KyberSwap, KyberDeveloper, KyberReserve, and KyberGO), Kyber 2.0 seeks to provide liquidity to a number of major user segments including mainstream individuals, projects, wallet providers, funds, token sale contributors, and token holders with substantial assets.

While the full Kyber Network 2.0 service suite is not fully launched, KyberSwap and KyberDeveloper were released in July, with plans to release KyberGO in Q3 and KyberReserve in Q4. Their decentralized exchange mainnet is deployed on the Ethereum network and currently lists 39 tokens with $215K in average daily trading volume.

Kyber is actively growing its user base through collaborations with wallet providers and token projects. Kyber Network currently have 16 decentralized projects integrated with their ecosystem, including MyEtherWallet and Request Network. Kyber is also working to provide peer-to-peer options trading and decentralized KYC compliance on their platform. Thus far, the Kyber team has reached all of its roadmap milestones on time, giving promise for the timely delivery of remaining objectives.

Moving forward, the team and investors need to monitor how the Kyber Network will handle increased traffic, trading volume, and liquidity requirements through their on-chain reserve pool system. To mitigate most of these concerns, the Kyber team is working on a scaling solution, Gormos, with significantly faster speed and more scalability than both Plasma and current sharding solutions, expected to release in Q3 2019.

OmiseGO (OMG)

OmiseGO is currently the top decentralized exchange project by market cap. Spun out of Omise, an established Southeast Asian online payment gateway. OmiseGO provides a platform for the decentralized exchange of assets targeting individuals both with and without access to bank accounts. OmiseGO is leveraging Omise’s corporate partnerships and the Ethereum network to grow its user base, as well as potentially offer interoperability with legacy payment gateways.

OmiseGO’s white label eWallet allows both individual users and legacy payment gateways to seamlessly participate on the OmiseGO network. OmiseGO seeks to provide asset-agnostic exchange via a network of smart contracts similar to Bancor and Kyber, allowing users to exchange digital or fiat currency for a different preferred currency. Users holding native OMG token validate transactions for a network incentive and transactions are cleared once the validation threshold is reached.

The largest threat to OMG’s future success is the fact that they are awaiting full deployment of the network. Full deployment of the platform isn’t expected until late 2018 or early 2019, which allows competing DEX’s to grow in market share, prevents investors from analyzing a market-tested product, and results in the token valuation not being rooted in usage metrics.

Waves (WAVES)

Waves is a platform primarily designed as an alternative launch vehicle for new projects instead of hard forks, soft forks, and air drops. These new projects are listed on the Waves decentralized exchange alongside other more established tokens such as BTC, ETH, and LTC, permitting immediate exchange capabilities.

There are technological issues with this means of issuance rather than the industry standard of hard forks, soft forks, and air drops and whether the industry would adopt it. Forking/air dropping offers projects the ability to tap into existing network effects, developers, and miners, while there are no substantial benefits from Waves, besides ease of launch and exchangeability.

Waves exchange has also been subject to a hack in July 2018, shortly after their full launch. While the attack was the result of a phishing scheme via their domain registrar and thus mostly out of their control, it still highlights a problem with their structure, in that the losses were irreversible. Waves’ whitepaper offers little discussion of the technological function of the project, nor the major issues facing decentralized exchanges.

Since Waves has not clearly elaborated on their technology and has past security issues, they are currently a much more uncertain DEX project.

Market data for top decentralized exchanges and blockchain market. 0x is one of the few that has fairly consistently outperformed the market.

Market Outlook

An evaluation of decentralized exchange technology clearly demonstrates there is a user need and that the technology is viable for adoption among retail investors. The current industry market cap is around $220 billion with just under $17 billion in daily volume. (Data from coinmarketcap.com as of 8/8/18.) Inherent value of the technology is driving market adoption and even major exchanges, such as Coinbase, are demonstrating interest.

As the blockchain market matures, more of the market volume will stem from institutional investors. Since the stock market is about 90% institutional investors, in the long-term we can expect retail blockchain investors to make up about 10% of blockchain volume. Given that not all retail investors will gain value from a DEX, DEXs should reach about 1–4% of market volume within the next two years. This would mean growth of 5–20x for DEX usage over the 2 years.

Based on technological development, 0x is the most sophisticated project and at least a few months ahead of any other competing projects. Furthermore, its established user base, solid growth rate, expanding project list, and history of performance and transparency make them clear leaders in the space. 0x has also demonstrated a high-level of security, whereas many other projects are less market tested.

0x is currently valued at less than OmiseGO, which has yet to launch, making 0x a growth opportunity as the technology is built-out further. While Kyber Network and OmiseGO are interesting technologies, neither has a fully launched exchange and will constantly be playing a game of catch-up in terms of user base size. Furthermore, there are still technological questions with the long-term efficacy of both of their platforms.

However, as DEXs will likely never take on institutional investor volume, an investment in DEXs should be paired with investments in high quality centralized exchanges. Additionally, opportunities to invest in custody agents would allow direct exposure to the growth of institutional investor market share. We are personally allowing for 15% exposure to DEXs in our portfolios, with a 5% investment in centralized exchanges.

As related to this article, within the last 3 months George Beall has invested long in ZRX, KNC, BNB, KCS, and HT and Phil Levens has invested long in ZRX, KNC, and BNB.