Decentralized Exchanges and Why They Might Be the Future
“I definitely hope centralized exchanges go burn in hell as much as possible,” – Vitalik Buterin at TechCrunch Sessions: Blockchain, Zug
Cryptocurrencies have made tremendous progress in giving users true ownership of their assets. As bearer instruments, the holder of any given coin is the owner of that coin — there is no external record of ownership, like with say, a deed to a house. If the coin is in your wallet, it’s yours.
However, the centralized exchanges used to trade cryptocurrencies — Coinbase, Gemini, BitMex, and the like — run counter to this philosophy, since one’s coins must be held on the exchange in order to trade on their platform. As such, centralized exchanges represent a single point of failure.
However, there is an answer to this problem in the form of decentralized exchanges. In essence, a decentralized exchange allows for peer-to-peer settlement of trades, eliminating the need to go through a middleman — in this case, a centralized exchange. Instead, execute trades between one another, through a trustless application.
Centralized vs. Decentralized
The primary difference between a centralized and a decentralized exchange is that centralized exchanges maintain control over funds and transactions. In general, users are required to deposit funds into an address owned by the exchange, which then manages order books and takes a percentage on each trade.
Centralized exchanges are required to store client information, private keys and transactions records. This is a single point of vulnerability, which has resulted in several exchanges being compromised, the notable being the Mt. Gox hack of 2014. Moreover, centralized exchanges are prone to technical and uptime issues, as well as regulatory oversight that could result in users’ funds being seized.
With the advent of smart contracts and decentralized trading protocols, decentralized exchanges have emerged to address these issues. Decentralized exchanges have the unique value proposition of users maintaining control over their funds, eliminating the any trusted third party (in this case, a centralized exchange) to facilitate trades. Instead of a centralized entity holding funds, users are required to send funds to an open source smart contract.
Early designs for decentralized exchanges involved maintaining order books on the blockchain. This structure has had several shortcomings, such as bloating the blockchain with unnecessary amount of transactions. In the case that a user might want to change the price or size in your order, they would have to put through another transaction. This is extremely inefficient and leads to scaling issues, like the ones facing Ethereum. However, by shifting from on-chain to off-chain order books, many exchanged have alleviated this issue.
The development of decentralized exchanges has been growing incrementally over the past few years, with milestones such as the launch of the 0x protocol. Applications built on the web3 stack, which are increasingly in need of liquidity, require a mechanism to trade tokens. This is where the 0x protocol comes into play. The 0x protocol has given rise to a series of relayers — analogous to an exchange that maintains off chain order books and charges a fee — that provide increased liquidity.
The current landscape of decentralized exchanges built upon 0x is still in its nascent stage, characterized by low volumes and low liquidity. However, there are some notable exceptions that are pacing the field.
Radar Relay, a relayer based on the 0x protocol, launched their beta stage in October 2017. The exchange provides a comprehensive API, which can power algorithmic trading bots. They have accumulated over $150 million in trading volume, which is a feat no other decentralized exchange has accomplished so far, and recently raised $10 million in Series A funding led by Blockchain Capital. Other notable investors include Distributed Global, Digital Currency Group and Kindred Ventures.
Another recently launched 0x relayer, Brooklyn-based TheOcean, is one of the first exchanges to feature TrueUSD as a quote currency. Some of the features planned include derivatives, cross chain swaps, and security tokens.
Decentralized exchanges are slowly growing, in terms of trades processed, user base, and funding. Should they continue to make technical advancements and gain traction, they could pose a real threat to existing centralized exchanges, which currently dominate the market, and allow for customers to trade and store their cryptoassets more securely.