2017 is nearly at an end and it has been quite the exciting year in the crypto world. I will spare you from yet more commentary on the recent happenings this year and focus on what I predict will be an important shift in the crypto world coming next year- the rise of the Decentralised Exchange.
Cryptocurrencies like Bitcoin and Ethereum are traded on exchanges all around the world in hundreds of currencies. Exchanges perform an essential use for price discovery for digital assets with buyers and sellers making accounts on exchanges to trade the currencies they have either for other cryptocurrencies or fiat national currencies. However one problem still remains where decentralized ‘trustless’ cryptocurrencies predominantly still trade on centralised exchanges subject to hacking, state oppression and banking shutdowns. It is always a risk to trade on a centralised exchange who are right now hammered with hundreds of thousands of new sign ups daily you better hope you dont need any customer support because you wont get any and the past is littered with a string of exchanges going bust, getting hacked or running away with the money.
The path to eliminating the counterparty risk involved in dealing with centralised exchanges is the development of a ‘decentralised’ alternative that is as secure as the blockchain protocols themselves and will be the topic of discussion today.
What is a ‘Decentralised’ exchange?
It seems everyone in the blockchain world has got to decentralise something, its a buzzword that not many people really understand but conjures up pictures of powerpoint slides with spider webbs showing how there is “no single point of failure, everything is connected to one another”- thats a useful starting point for envisioning what a decentralised exchange is I guess. A decentralised exchange or ‘DEX’ is a piece of software that acts as the wallet and order execution engine for everyone who also runs that particular piece of software. Think of it like a wallet with an inbuilt exchange. If you have multiple cryptocurrencies, everyone with the wallet can trade the coins between each other in a P2P system without any counterparty taking custody of the coins with each party able to interact directly with one another with settlement guaranteed by the blockchain. Given ‘crypto only’ exchanges these days do greater volumes than most national stock exchanges (Bittrex today did $3.5bn in volume and they dont support fiat currencies) this is an important area of growth and a big systemic risk.
Trading without a counterparty anywhere in the world only by downloading a piece of software is very exciting. One does not need to trust that the exchange website will still work, still have your money, not get hacked or someone respond to your support ticket- your wallet is the exchange and you own your wallet.
DEX’s have been around the block….chain
Various decentralised exchanges have existed for many years now in varying forms:
First you have the Over The Counter (‘OTC’) type DEX’s that play the role of connecting willing buyers with receivers and letting them handle settlement between each other, think link Localbitcoin.com but without the centralised website- e.g. Bisq. These exchanges are often used for fiat/crypto trading pairs where settlement is impossible to take place on the blockchain (as it involves fiat in peoples bank accounts) and instead relies on party_A making a transfer to party_B’s bank account and Party_B delivering the crypto which is held in escrow by the protocol (release can be triggered by both parties or a third party approval). Individuals on these platforms may build up trust and historical information to support their ability to conduct settlement with people opting to trade with parties with a good reputation for delivery. The main benefit to this type of DEX is immunity to censorship. It is impossible for a government to shut this down and impossible for banks to know the two parties are transacting cryptocurrency, for all they know one person sent another person a bank transfer. In countries like Venezuela or China where there is pervasive state censorship, this is the ideal method of entering and exiting the cryptocurrency world.
Secondly and an area in rapid development are full orderbook DEXs that operate and look exactly like a trading desk you may see on Bitfinex but in a decentralised manner (no counterparty risk in custody and settlement of assets) and paired with pegged cryptocurrencies (cryptocurrency pegged 1:1 with a national currency like BitUSD) they are a step towards solving many of the issues with centralised exchanges going forward into 2018. Objectively, the longest running and most advanced DEX is the Bitshares DEX which has been in operation since 2015 and features full orderbooks + settlement on-chain, 200% collateralized decentralised pegged cryptocurrencies, stakeholder voting and more. These settlement DEX’s fulfil almost all of the requirements needed to entirely replace the need for a centralised exchange like Poloniex or Bittrex.
The only issue for settlement DEXs is getting the crypto into and out of fiat in the first place, once its in crypto you can trade it for anything but getting it in and out will inevitably mean interacting with the legacy financial system. The school of thought on this is either A) Integrate OTC markets like the OTC DEX above or B) Enable centralised ‘gateways’ to connect to the DEX and be the portals into and out of fiat- Bitshares does the latter.
How Gateways Work
A Gateway is a centralised company which connects to the DEX and lists tokens on the DEX which represent real world things. These things could be a fiat bank balance for example, so when you deposit $100 at a gateway, they could issue 100 GatewayDollars tokens on the DEX. You could then trade your GatewayDollars tokens for other assets on the DEX knowing that it is backed by the gateway who issues them. Of course, this method creates a counterparty risk with the gateway- their tokens are only as good as the market thinks they are (for example are they really backed 1:1 with the money in their bank? What if they lose their bank account?), luckily in Bitshares you could easily trade gateway tokens for collateralised decentralised pegged cryptocurrencies with zero counterparty risk so if you wanted to hold a fiat balance on the DEX this would be the recommended means of doing so.
The benefit of gateways is enabling outside assets to trade on the same blockchain trustlessly. You cannot (yet) directly connect the Bitcoin blockchain with the Ethereum blockchain and send payments trustlessly between each other. By using a Gateway which can create tokens representing other blockchains and assets they can all trade on the one blockchain but you need someone to create them.
An existing centralised exchange like Bittrex is essentially a gateway but it is not built ontop of a blockchain. Bittrex receives your Bitcoins and then at their discretion credits your account with them with something to trade called ‘Bitcoins’. These are no longer your bitcoins, you dont own the private keys, theyre Bittrex’s coins and theyre issuing you an IOU for Bitcoin on their system, similar to how a Gateway on Bitshares might issue you a GatewayBitcoin to trade on the Bitshares DEX. The key difference however is that when you hold a balance and trade on the DEX you are in possession of the private keys and assets on your account, its your money, Bittrex on the other hand owns the private keys and you hope you can oneday extract those IOUs for the real deal.
Atomic Swaps and the rest
Lots of ICOs like to use the word ‘atomic swaps’ which is the new buzzword, what it means is being able to trustless transact between two dissimilar blockchains- for example Bitcoin and Ethereum with a clear application being a decentralised exchange. Such a system linking all blockchains together to transact trustlessly is the holy grail of blockchain interactions at the moment and we have already seen it working with some blockchains in the past (litecoin and bitcoin for example). This would theoretically remove the need for the Gateway to issue on-chain equivalents of other blockchains and instead enable users to transact natively with their cryptocurrencies directly.
There are many protocols looking to enable greater use of DEX’s, in Ethereum a prominent contender is 0x which provides the protocol layer and tools necessary for the exchange of Ethereum tokens in a DEX or for Gateways to gain access to such a system. 0x is gaining traction with a number of development teams and likely 2018 will see a working implementation to the public however likely only to connect Ethereum based assets.
2018 and The Rise of the DEX
The issues plaguing exchanges today can be abated by switching to a trustless mechanism of exchanging digital assets. Whoever will become the dominant player in this space remains to be seen but the opportunity is clear given the customer dissatisfaction with exchanges of late. For DEX’s to be a success they need to meet the following criteria:
- Seamless user experience for deposits/withdrawing and trading cryptocurrencies
- Full orderbook with deep liquidity
- Settlement on-chain
- Low fees
- Create new assets simply on the DEX
- Fast transaction throughput and order matching
- Solve the fiat problem
- Trustless fiat pegged cryptocurrencies
These would be my list of ingredients to make a decentralised exchange with a value proposition clearly more beneficial than a centralised alternative. It is inevitable that DEX’s will reach critical mass as there is simply no need to trust a custodian of your digital assets when it is technically possible to exchange them without a counterparty. At the moment Bitshares is only system which meets most of the above criteria, more will arriving in 2018 and it will be the next catalyst for cryptocurrencies to continue their rise as a means of transacting value or tokenizing assets and ideas.