The next generation of crypto exchanges has one big missing piece
It seems very likely that 2018 will end up being a banner year for a much-hyped crypto development.
Decentralized exchanges, which were publicized as a way to put actual custody back into the hands of traders, have moved out of R&D stage and are registering early adopters. But before investors can start celebrating, there is a severe problem that entrepreneurs think is stopping the model from challenging the likes of Kraken and Coinbase.
Simply put, you need liquidity to get adoption, yet to get adoption, there must be pretty good liquidity, a fact recognized by even those who know how beneficial more high-tech trading offerings are.
But in a realistic point of view, it’s worth checking out how centralized exchanges solve this puzzle. Most of the times, they make deals with market makers to motivate them to create liquidity. These motivations usually come in the form of a reward or rebate that’s exchanged for the assurance that a particular amount of what traders refer to as “order book depth” is always maintained.
Some centralized exchanges will even solve the problem by applying temporary strategies, like market making themselves with their capital, and will practically duplicate order books from other more liquid exchange platforms (plus a spread) to try to pull in traders.
There are some practical problems: decentralized exchanges can only trade in cryptocurrencies. That implies people can’t really use fiat currencies like US dollars to purchase a token. They first have to visit a regulated exchange to buy bitcoin or ether with their fiat currencies.
Once they’ve gotten bitcoin or ether, they can head to a decentralized exchange platform to purchase the more tokens. Therefore, it’s perhaps unsurprising that this can all seem a bit much for those familiar with more user-friendly Wall Street solutions.
As the CEO of Pactum Capital, Daniel Cawrey explains:
“Most investors are already frightened by bitcoin. So, to make them leap through hoops to trade on a decentralized platform to trade a coin with a small market capitalization causes most people to give up.”
Cawrey describes it as a subject of cost and benefit. Mainly, when it comes to trading volume, most tokens don’t do much, which makes the set-up difficulties even more prominent.
That aside, there have been early achievements.
For instance, the decentralized marketplace for ethereum tokens, AirSwap, which launched last week, executed transactions worth more than $1 million on its first trading day.
A different perspective
Still, those putting in efforts to create this business model see it differently.
AirSwap which was co-founded Michael Oved goes so far as to use a bulletin board-style method that emulates the way retail forex traders interact with each other directly p2p.
The platform substitutes the conventional order book with some sort of search engine named an “indexer,” whereby traders can declare their interest in trading, making it possible for their peers to discover them using smart contracts. It trades some 25 tokens at the moment, but that is bound to increase anytime soon.
In this way, Don Mosites, a co-founder of the AirSwap platform thinks this selection is enough to overcome the issues discussed by Cawrey, as the platform will be offering a small selection of coin initially, but will steadily grow in volumes.
Yet, this isn’t the only way to solve this problem. Smart developers are releasing IP with different ways to decentralize ethereum token trading while pulling the required liquidity.
For instance, KyberNetwork, an exchange established in April, has also removed the order book from its platform and owns a reserve warehouse guided by a Kyber smart contract.
To draw as much liquidity as possible from Singapore’s booming token economy, Kyber runs an open model – by interacting with the smart contracts, anyone can be a market maker or taker.
“We solve the liquidity puzzle by attracting the market makers to our platform – anyone with an ample amount of idle assets or even the issuers of the coins,” the co-founder of KyberNetwork, Loi Luu said. ” By market making on our platform, they can get more profits on their idle assets.”
The 0x protocol, which offers the choice of being open or closed to exchange operators building on top of its smart contract system, is also looking to use the explosion in ethereum tokens to its advantage.
Using 0x in a completely open and decentralized way aims at capturing a networked liquidity effect. This implies the smart contracts that ultimately execute trades are set so that any user can fill the trade maker and takers.
But the 0x protocol can also be used to develop a closed order book, or matching model, where the smart contract is fixed so the trade taker is always the relayer.
There are trade-offs, as with most things in a decentralized setting.
While the liquidity problem may be resolved as time goes on by openness, it creates an easy means of front-running trades. This can occur on the Ethereum Network when users see market-moving orders and fix a gas price for their transaction greater than the transaction they’re viewing.
The CTO of 0x, Amir Bandeali, pointed out this problem shouldn’t be put exclusively on decentralized exchange services.
“This is not an issue that’s specific to trading; front-running is one of the larger problems of blockchains in general. If anyone tenders a transaction to the blockchain, the whole transaction is public before mining,” Amir said, continuing:
“But because decentralized exchanges are one of the first working use cases the blockchain technology, they have been receiving a bad blow for this.”
To strengthen the open approach, 0x is considering introducing functionalities like a coordinator for trade execution, or an embeddable trade widget for open order books that can let wallets and other apps monetize by merely rebroadcasting orders from different relayers.
Kyber, which is also open, excludes the ground of front-running by narrowing the transaction value on each trade. Currently, the trade size is capped at SGD 5000 per trade for unverified users and SGD 10000 SGD for verified users.
An exchange founded by trading platform veteran Ron Bernstein, Paradex, is combining the 0x protocol with a closed order book model is. In this configuration, settlement of trades takes place on the Ethereum Network, but a closed matching model endeavors to maintain functionalities that professional traders need such as price/time priority and best-price guarantees.
“The matching model does have trade-offs,” Bandeali said. “It renders your relayer much less open to smart contracts. One of the main advantages of the open order book model is that you can atomically execute trades with other transactions, as well as other trades. Using the matching model, you can’t really benefit from this.”
Bernstein confirmed that matching does not permit Paradex to participate in 0x’s ambition for profitable shared liquidity, but he emphasized the trade-offs are unique.
“There’s a tiny chance that shared liquidity will be a widely adopted solution. It may be a short-term advantage while bootstrapping relatively new trading environments such as decentralized token trading.” Bernstein said.