User Groups

The DutchX #6

To us, the traditional order book model of centralized exchanges — a continuous auction model executing orders one-by-one — seems inadequate to be implemented on the blockchain. The DutchX applies an entirely different design which we find more suitable to the technological environment of the blockchain, and we’ve shown in our last post that it results in a number of benefits for participants: the batching of sell orders allows sellers to include market orders of any size without resulting in quick price movements or spreads, for example, and it also allows traders to choose low gas prices for their orders — given the slow execution time, they are not in a rush to execute. Let’s take a closer look at the different user groups and how they each have their unique advantages in the DutchX.

Participation as a Seller

As the DutchX smart contract batches sell orders and executes these at once, there is only one market clearing price. This takes off the burden from sellers to be industry experts and hence have a precise idea of what they personally would consider as “the right token price”.

Due to the application of game theoretical behavior, the Dutch auction mechanism results in a fair market price. This is supported by only running auctions when a critical threshold is met, as well as helping market makers get familiar with this new mechanism to be able to participate as bidders and provide liquidity. The DutchX mechanism is not only great for determining the true market price by setting the right incentives for bidder participation, but it also stands out in disincentivizing those that we consider to be extracting value from exchanges, and ultimately leading to suboptimal prices: high frequency traders, front-runners, and those doing arbitrage from overlapping order-books.

While no account is needed to trade on the DutchX, you will need a wallet holding ERC20 tokens in order to participate. The DutchX is compatible with supported wallets for ERC20 tokens, which are automatically linked to the interface. Although you may also use ETH as a sellToken, fiat currencies such as USD or EUR are not supported.

Apart from that, the DutchX mechanism design allows sellers to include market orders of any size without quick price movements (“slippage”), i.e. triggering order book spikes as known from traditional order books. Similarly, sellers do no longer have the opportunity to take advantage of short-term price volatility — due to the automatic on-chain order matching with one clearing price, essentially, there is no spread between bids and asks on the DutchX.

Consequently, sellers do not need a strategy to trade in the DutchX — they simply submit the tokens they want to sell into the auction for which they will receive a fair price in return once the auction clears. It is important to understand that a seller will face less volatility than on other exchanges — but of course this can go either way! If you are unsure about what price to expect, are rather risk-averse, and have a longer investment horizon than a day-trader, the DutchX is the right place for you: Sell orders in the DutchX may be considered as slowly executed, safe market orders, which may be submitted anytime and do not depend on closely monitoring market prices and making sure to submit the order at the best moment.

Participation as a Bidder

When an auction for a token-pairing starts in the DutchX, the initial price is set at twice the final closing price of the previous auction (of the same pairing). From this initial price, the price falls according to a decreasing function. During this state, bidders submit their bid at the point in time where the current price reflects their maximum willingness to pay. Since all bidders will only pay the final market clearing price at the auction’s closing, which is either at their bid or lower, they have an economic incentive to submit the bid at their highest willingness to pay, factoring in platform liquidity contributions as well as gas costs.

Bid orders in the DutchX may thus be considered as an equivalent to limit orders, but with a high chance of getting an even better price than the amount indicated at the bidding time: As a result, it pays off for bidders to reveal their true willingness to pay — no other strategy is needed.

We expect bidders in the DutchX to be more professional traders:

1) Bidders have to be active at the precise moment during the auction process where the price reflects their true willingness to pay — or alternatively write a locally-run script for their participation.

2) Bidders need to be aware of their true willingness to pay for a specific token (expressed in relation to another token).

3) For the first release of the DutchX at least, bidders will need to be able to interact with the exchange on a smart contract level (via trading bots f.ex.) since we are not aware that anyone will provide an interface for bidders at this point.

Bidders are also able to request a partial payout at any time during an auction. If triggered for the first time, this first payout would be the minimum possible payout that the bidder would receive at that moment in time. After the first payout, the bidder will be issued the difference between the already received payout and the amount of tokens s/he would receive at the current price point. This ensures that bidders don’t have liquidity locked.

Market Makers

Market makers provide liquidity to the market. Although the points mentioned below are not specifically targeted to market makers, they are likely more pronounced for this user group due to the high volume they provide:

When participating in the DutchX from the very beginning, market makers can significantly decrease their liquidity contributions up to 0.1%. Additionally, since we allocate the liquidity contributions not paid in OWL to the next running auction of the same token pairing, market makers are even able to obtain the liquidity contributions of other participants thanks to a redistribution model.

Consequently, market makers become the main beneficiaries of the exchange: They can gain ownership of the exchange by generating Magnolia tokens and hence reducing liquidity contributions, and even benefit on a large scale from the liquidity contributions paid by others.

If you’re a market maker and would like to get familiar with our specific mechanism, please do get in touch. We’re happy to help you understand the DutchX, explain how market making on it would work and how it differs from other exchanges.

Participation as part of a Special User Group

New Blockchain Projects

Getting listed on other centralized and decentralized exchanges is an extremely tedious and costly process for new blockchain projects. Centralized exchanges don’t publicly advertise their listing liquidity contributions, but these are known to run into the hundreds of thousands of dollars, and up to $1 million in some cases, depending on the size of the exchange. Centralized exchanges enjoy a position of power in the crypto market as access to larger ones often represents the difference between success and failure for many projects: The bigger the liquidity pool of an exchange, the higher the potential market value of a coin, and hence the higher the chance of success for a project.

However, once liquidity contributions are paid, being listed on one of the major centralized exchanges isn’t necessarily a safe haven. The exchange can always change its rules and decide to delist a token project.

In the DutchX, blockchain projects can benefit from an immediate listing, without having to bear high listing fees. For a new token pairing to be listed, the auction simply needs to be funded with at least $1,000 worth of ETH as sellTokens. Please note that the money is not actually spent, it’s simply being exchanged!

Apart from the listing that is the same for all tokens (new and old), new blockchain projects can also benefit from a reliable price feed for their token, and obtain liquidity contributions reductions as well as liquidity contributions redistribution benefits by holding Magnolia. Redistributed liquidity contributions will remain in the same pairing — i.e. bidders and sellers of your token will enjoy this benefit!

Listing a token on the DutchX might also be a great way for new projects to attract long-term investors and keep away high-frequency and day traders. For more information about how to list a token on the DutchX, see this article.

Other Smart Contracts

The DutchX may also be used by other smart contracts. Most other decentralized exchanges require to either sign an order off-chain or receive a signed order off-chain and then submit it to the blockchain. A smart contract can do neither. Even with a decentralized exchange based on an on-chain order book, the smart contract would need to implement a strategy on how to place the order, which might be very challenging on-chain. On the DutchX, everything is done on-chain: from placing orders to their execution. In addition to that, participation does not require any special strategy. Those in need to exchange tokens could be DAOs, for example, or those implementing more advanced financial instruments or prediction market platforms. Gnosis’ prediction markets will integrate with the DutchX in the future to make outcome tokens peer-to-peer tradable.

Crypto Funds

Crypto funds with a long-term investment incentive often are unsure about the “correct” market price of a token — they fully trust their fund managers who are supposed to be industry experts. If fund managers would start trading tokens on the DutchX, trust won’t be needed anymore: funds would be assured that they’ve obtained a fair value for the exchange of the token.

Token Buy Back

Blockchain projects sometimes need to buy back tokens — as a ‘burning’ process with a deflationary effect on the total token supply, and as a result, bringing up the token price or at least stabilising it in a moment of downturn. However, it often is hard to do so in a fair and transparent way — many projects use various exchanges to buy back tokens over a longer time frame in order to smooth out any price fluctuations.

When companies buy back shares on the stock market, they announce the buyback program, and then repurchase shares in the open market, over a period of several months or even years. Most countries have strict regulations for share repurchases in order to make sure that its shareholder interests are protected, and that the company will not profit from its private information. For example, repurchases are prohibited when the management holds information that is not disclosed publicly. In the US, a guide for executing open market repurchases is the Securities and Exchange Commission (SEC) safe harbor Rule 10b-18 under the Exchange Act of 1934. The Rule 10b-18 provides companies with a “safe harbor” from liability for manipulation when they repurchase their common stock in the market in accordance with the rule’s conditions, such as the manner of repurchases, the timing, prices paid, and volume of shares repurchased. In December 2003, the SEC also specified more detailed disclosure requirements for repurchases [1].

Using the DutchX to buy back tokens allows not only for a fair price finding mechanism, but also for advanced communication about the buy back process — which could ultimately become the self-regulated best practice for companies wishing to buy back tokens. In the DutchX, the project can flexibly decide on the timing and specifics of the buyback (may it be over the course of one or several auctions), while being able to be fully transparent about the process. That being said, this is not legal advice and we cannot comment on the regulatory guidelines around token buy backs in various jurisdictions.

Token Sale

Token sales are likely not a typical use case of the DutchX as the longest time an auction can potentially run is 24 hours. We plan on integrating this feature in a possible next version of the contract. However, projects could make their token available immediately after the token sale, without having to bear high listing liquidity contributions that other centralized exchanges demand.

Who won’t be a User Group in the DutchX

Due to its inherent auction mechanism, the DutchX is not instantaneous which makes fast trading impossible. While the Dutch auction will partially remedy this problem for buyers, it is, however, often secondary to achieving a fair price for most users. Therefore, high frequency traders or day traders will surely not belong to one of the DutchX’s user groups.

To us, this actually represents an asset as it highly reduces arbitrage opportunities (also due to information and speed advantages) — arbitrageurs bring liquidity to markets, but do this by exploiting cross-market inefficiencies. When designing the exchange, our aim was to create better market mechanisms. Hence, the DutchX mechanism benefits everyone not practicing arbitrage.

Now that you’ve learned all about the different user groups, we’re looking forward to sharing some FAQs in our next post!

[1] Ginglinger, E. and Hamon, J., 2005: "Share repurchase regulations: do firms play by the rules?", http://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2006-Madrid/papers/557508_full.pdf.

Thanks to Chris and Friederike.