The Dark Side of “Decentralized” Exchanges

With the blockchain industry growing by the day, the word “decentralization” has become adopted by projects left and right looking to co opt the term for their own financial benefit. This narrative is playing out heavily in the arena of decentralized exchanges (DEX), where projects are touting their full decentralization and superior functionality, only to leave users with platforms that are cumbersome, expensive, or not operating in a decentralized fashion in any way. While the concept behind a decentralized exchange makes sense for cryptocurrency traders, it must overcome the problems displayed by many of the current market solutions.

Is it really decentralized?

As users of Etherdelta recently found out, a decentralized exchange plus centralized hosting equals big problems. As long as the entity operating an exchange is utilizing centralized hosting or any other type of centralized off-chain functionality there will always be a risk of a malicious attack or issues related to trust-based systems. If decentralization is being touted by an exchange it must apply not only to the exchange of funds itself, but to the nature of maintaining the exchange as well as its software, data storage, and servers.

To add fuel to the fire, an exchange operated by a centralized entity is likely still subject to regulations by the SEC, CFTC, and FinCEN making its future dependent on how these agencies decide to qualify the exchange as truly being decentralized, or just using “decentralization” as a matter of marketing. At the very least they may be subject to know-your-customer (KYC) and anti-money-laundering (AML) laws requiring users to disclose their personal identity information.

Blockchain Without the Chain

It is common for a DEX to tout decentralization when it performs transactions off the blockchain before settling those same transactions back on the chain. However, this misses the point of utilizing blockchain technology in the first place, leaving the question if exchanges like 0x are really utilizing blockchain technology in the way its users have been led to believe. Taking transactions off-chain, while solving the issue of orchestrating large quantities of transactions with minimal gas costs for order matching, eliminates the benefits of trust-less, decentralized transacting on the blockchain in the first place, rendering such exchanges functionally viable but not true decentralized solutions.

Crypto-pegged Tokens

An additional layer that has been added to many DEXs is the function of pegging tokens to digital assets. DEXs like as Waves, Bitshares, and OpenLedger do not allow users to trade in cryptocurrencies directly, and instead, require all trading to be done via crypto-pegged tokens whose value is pegged to that of an underlying digital asset.

Not only does this add extra steps to the trading process, having to trade in and out from pegged tokens to digital assets (and then to fiat if desired), it requires additional faith in the exchange to maintain the pegged price of a token to its underlying digital asset. Beginner cryptocurrency traders may not understand that when trading in such tokens they are not actually trading in the cryptocurrency itself, but a fabricated coin built on smart contract technology designed to mimic a specified cryptocurrency. Reported manipulation of the industry’s largest pegged token, Tether, should worry users as to what is securing the price of proxy tokens they are trading.

Order Matching

It is all well and good to provide decentralization in an exchange, but if users have to source and find their own orders in a peer-to-peer fashion, such as on LocalBitcoins and Bisq, the exchange is only acting as a defacto Craigslist for cryptocurrency, and not providing enough value to its users.

A decentralized order book is necessary to maintain the best value for users. However, some DEXs like Waves, which claim to maintain full decentralization, match orders through one centralized node, eliminating any claims of decentralization on the exchange. Centralized order matching once again brings to surface the issues of centralization that users are trying to rid themselves from, such as trust in a third-party and susceptibility to a malicious attack and loss of funds.

Another problem with order matching is the requirement to hold funds in a separate escrow account to secure trades, slowing down the trading process for both buyers and sellers. This once again forces users to trust intermediary escrow accounts to secure their funds and function as intended.

The Solution

The only way for a decentralized exchange to thrive is if it’s structured in a fully decentralized way, with no one entity benefiting from its existence and usage. This means eliminating extraneous fees for using the platform along with control by any one individual entity, while still providing a platform for secure and fast trading.

R0gue is a decentralized exchange protocol built by The Enzo Foundation for performing any transaction on the Ethereum blockchain in a peer to peer on-chain solution. Through this protocol any Ethereum-based token can be traded on the exchange. This is a huge benefit to new tokens, which can be listed on the exchange without any fees or distribution of coins to the exchange itself, something that is far too common on both centralized and decentralized exchanges.

(Side note: As we were developing r0gue, we were approached by a number of ICO startups willing to offer 5–10% of their tokens for just being listed on our protocol, before they knew it would be free and Enzo doesn’t act as a gatekeeper. Apparently this is the generally accepted under the table deal you find in the industry…)

The r0gue protocol places the off-chain function of order matching into the hands of users themselves, and away from centralized third-parties. A user’s local node sends a hint to the blockchain on where to insert their order rather than paying on-chain gas for the peer contract to do the work. As it is off-chain and decentralized, it becomes a free process to optimize order matching! In this way, users perform the function of a centralized party, like 0x would have previously performed, except without the added fee for doing so. (I would hate to be a holder of ZRX right now…)

It’s our hope that the creation of a decentralized exchange protocol designed solely for the benefit of its users will be a welcome solution for an industry fraught with fraud and illegitimate claims. The Enzo Foundation will be releasing r0gue on the Ethereum (and possibly Ethereum Classic) network(s) with the hope of spreading pure decentralization and enabling monetary freedom. Follow us on twitter @enzo_foundation for info on the release of r0gue and updates on applications to come built on the r0gue protocol.

Let me know your thoughts in the comments section below! I’d like to know if people are as cynical of the blockchain industry as I am XD