The prehistoric, the past, and now.
Introduction
Bitcoin made the possibility of decentralised money as early as 2009. The infrastructure to exchange it for other goods, digital assets and services did not formally establish itself until much later. Be it trading pizza for 10,000 Bitcoins or the Mt Gox hack of 2014 — the ability to discover counterparties and transact in a trustless fashion has been a necessity for the industry to evolve.
This is why Ethereum mattered a lot when it came. In spite of multiple attempts to create programmable assets with Omni and coloured coins, it was the speed and programmability of Ethereum that enabled the evolution of DeFi to happen over the past few years. In this post, we will be exploring how the evolution of trustless transaction has happened between 2014 to today and the trade-offs that came in each.
Decentralisation as they say — is a spectrum. In each of these variations, we will observe that there are certain trade-offs that come in each.
2014–2017: The dawn of smart contracts
Asset-based exchanges were available in the industry as soon as 2014. Nxt Coin used proof of stake and allowed individuals to issue their own assets in their asset exchange. These were in turn used for running smaller-scale ventures that were similar to present-day ICOs. Since the community and market for these “alternative” coins were much smaller, the possibility of listing these coins on a prominent exchange was rather low. Instead community members traded against one another directly through the coin’s wallet client.
The liquidity on these decentralised exchanges was a fraction of what we see today and it was not possible to meaningfully scale them. Another trend of the time was the rise of peer to peer exchanges like LocalBitcoin that made it possible for individuals to acquire digital assets without going through a centralised exchange.
This was critical at a time when regional currency based centralised exchanges were not available. Anyone holding Bitcoin could simply open an escrow on Localbitcoin and release their coins to the buyer once they confirmed a deposit of money. This was however custodial in nature and largely required the team from LocalBitcoin to intervene in the instances where a scam occurred.
More recently, the platform has also made it necessary for individuals to do AML/KYC on the platform in order to be able to access it. This makes it harder for individuals in regions such as Venezuela, Argentina, Iraq and the like to use the platform as they are constantly at risk of being detected by members of authoritarian governments.
2017–2018: Order-Routing & Orderbook based exchanges
The rise of ICOs in 2017 made it necessary for individuals to be able to issue an asset and find liquidity for it without necessarily going through centralised exchanges. At its peak, it used to be common for exchanges to request millions of dollars for a listing which in turn increased the asset’s price and was often seen as an investment.
However, during the frenzy of 2017 — it became clear that smart contracts are powerful enough to issue and settle assets in proportion to the currency that is sent to it. This laid the basis for a new generation of exchanges. Ones that were primarily run through smart contracts.
A key leader of the time was IDEX and Etherdelta. Between high gas costs, low liquidity and thin books, the exchange was barely comparable to a traditional alternative but it gave much-needed liquidity for those looking for it. A challenge that emerged from this era was that although much of the order settlement itself happened on smart contracts, the front-ends for these platforms were hosted on servers that were well within the jurisdiction of regulators. More importantly, given that the members behind these projects were identifiable, they were prosecuted by the government for running a non-compliant exchange in due time.
Another key innovation of the time was order routing systems like Kyber and 0x — both of which incentivised automated market-makers for providing liquidity for exchanges. Ethereum’s composability meant any platform could integrate Kyber or 0x into it and have a ready solution for exchanging assets without going to a centralised alternative. These systems functioned in a peer to peer fashion without an open-orderbook interface. They laid the plumbing for the next generation of exchanges — Automated market-makers and aggregators.
2018–2020: Automated market-makers & Aggregators
In 2018, Uniswap launched a liquidity pool based exchange where individuals were incentivised to park assets in exchange for receiving a cut of the transaction. These typically depending on:
(i) a rebalancing of the pool as individuals purchased and sold assets and
(ii) arbitrageurs ensuring the price of assets broadly stayed in sync with centralised exchanges.
As stablecoins took off, projects like Curve enabled much deeper order-books as stablecoins typically traded between a very thin price range. Markets had now evolved far from 2014 where total dex volume was around a few million dollars. In comparison, exchanges like Curve could now enable the exchange of millions of dollars with tighter spreads than their centralised counterparts. Spread were also tightening during this era due to a new product segment in the market.
Aggregators and order routing systems.
Projects like 1inch made it possible for a single order to be routed through the exchange offering the best exchange rate. 0x’s Matcha.xyz took the experience one step further and made it more retail friendly. However as we witnessed with a recent hack incident involving routing money through 1inch, the elements of centralisation in terms of the front end being controlled by a centralised entity is very real. Users can be identified on basis of the data trails they leave when they use these products. In addition, these smart contract-based products have sent gas costs on Ethereum soaring high over the course of the past quarter.
What the future holds
As Arjun Balaji wrote in his recent post around market-structures in crypto, we are increasingly moving towards a phase of hyper-scale and institutionalising within the DeFi ecosystem today.
One way this will play out is with increased multi-chain interactions due to the arrival of projects like Polkadot and Cosmos. We are already seeing this occur with close to 1% of Bitcoin’s circulating supply slowly porting towards Ethereum as wrapped variants on the network.
In addition, layer two based projects such as Loopring and Diversify will make it possible for a new generation of institution-grade market interactions to be possible. For one, trades per second will be more in similarity to what a centralised exchange can offer. Centralised exchanges already see this threat and are thereby leading the charge on change.
Coinbase’s acquisition of paradex in 2019 was the first step towards this. In 2020, they listed DeFi based coins much faster than most other categories of assets. FTX took this a step further by being actively invested in multiple DeFi projects and being a key player behind Serum.
Similarly, Binance Smart chain is slowly plugging the CeFi and DeFi world together. Going into 2021, we will see an increasingly large number of traditional market-makers and hedge funds entering the DeFi space.
We are witnessing early signs of it with institutional demand for yield recently. Coin list has begun offering its clients the ability to generate yield through capital parked with them.
At Zeroswap,
We have been building products that enable this transition in particular. Our focus on Layer 2 ensures that users will be paying zero fee as compared to the existing exchanges.
Combining this with the fact that we will be multi-chain compliant early on will mean we have better liquidity and deeper order books for a much wider variety of assets.
On the same vein, we will also be looking to make the exchange itself free of fee while rewarding individuals with tokens for providing liquidity. Our hope is that this attracts large market-makers into the product while reducing the cost for the average retail user to exchange their digital assets.
Most importantly, we will be focusing on gradually decentralising the governance of the platform itself over time. Thereby making it possible for our most committed users to have a say in how the platform is run.
We hope to see you join us on this journey in gradual decentralisation.
