Cryptocurrencies are beginning to permeate the traditional financial system, shining a spotlight on the exchanges used to trade these cryptoassets. Although Bitcoin, Ethereum and other ‘blue-chip’ decentralized cryptocurrencies have shown resilience against malicious actors and government intervention, the exchanges on which they are traded provide a single point of failure, which has resulted in numerous hacks and general uncertainty.
Decentralized exchanges offer a solution as they allow users to retain control of their funds throughout the trading process, remember ‘not your keys, not your coins’.
We take a look at two different classes of decentralized exchanges, those that make use of off-chain orderbooks with on-chain settlement and those based on smart contracts, as well as some of the regulatory questions surrounding DEX’s.
The Added Value of Decentralizing Cryptocurrency Exchanges
The way cryptocurrency exchanges traditionally work is as follows:
A user deposits either fiat or cryptocurrency into their account and their balance on the exchange is credited. They then utilize the exchange’s order book and liquidity pool to buy the assets they desire and sell the ones they don’t. However, users have no control of their private key and hence, no control of their funds.
Aside from being against the spirit of decentralized finance, these centralized exchanges have proven to be the Achilles heel of the cryptocurrency markets. The bear market of 2014-2015 was triggered by the monumental hack of Mt. Gox, as the Japanese exchange saw hackers make off with 750,000 - 850,000 bitcoin, worth approximately $450 million at the time. Just recently Coinrail was hacked causing panic in the market.
Since these exchanges function as centralized custodians of customer funds, they serve as a single point of failure liable to be targeted by both hackers and government intervention. With decentralized exchanges however, users control their funds until such time as a peer-to-peer trade is executed. The absence of a centralized server executing these trades increases the security of the trading process. Being a distributed ledger-based trading system means a hacker would need to commandeer more than half the network to compromise the system.
Another concern surrounding legacy crypto exchanges, especially by virtue of being unregulated entities, is that they are subject to all manner of manipulation. Centralized exchanges can also engage in front running, a process whereby an exchange inserts its own order in anticipation of big price movement. In regulated markets this is illegal and policed. Decentralization reduces the risk of front-running taking place and destroying investor trust.
There are three classes of decentralized exchanges
Currently, decentralized exchanges are being developed along three avenues:
- On-chain orderbooks and settlements
- Off-chain order book with on-chain settlement
- Smart contract-managed reserves
On-chain orderbooks and settlements
The architecture of the first generation of DEX’s was entirely blockchain-based. Every new order or adjustment to an existing order updates the state of the blockchain. Despite protecting user privacy and security this method renders exchanges illiquid, slow, expensive, and inoperable with one another.
Off-chain order book with on-chain settlement
The 0x protocol, built on Ethereum, introduced a solution in the form of off-chain order books. While the execution of trades occurs on the Ethereum blockchain, giving users control of their funds until the exchange takes place, the order books are hosted by third-parties called Relayers.
These Relayers host and maintain order books and using the 0x architecture they can pool their liquidity together creating a more robust trading infrastructure. After submitting an order to the Relayer, a market maker waits for a taker to fill that order, at which point the trade is trustlessly executed on the blockchain.
Smart contract-managed reserves
In addition to the two main hurdles faced by centralized exchanges (they are prone to government intervention and hacking), this model of connecting buyers and sellers functions sub-optimally when there is low liquidity. This problem, introduced by William Jevons (1875), is known as the double coincidence of wants. He reasons that “the first difficulty in barter is to find two persons whose disposable possessions mutually suit each other's wants.”
With smart contract-managed reserves, instead of having to find a buyer for the bitcoin, a user can trade with an external reserve, depositing bitcoin into the reserve and receiving ether in return. In the case of Bancor, an Israel-based project which raised $153 million through an ICO in June 2017, the smart contract facilitating this trade utilizes a precise mathematical formula to control the exchange rate between the two tokens which is based on an agreed-upon Constant Reserve Ratio (CRR.)
For example, the ICO saw the release of the BNT token which was backed up 20 percent by Ethereum raised in the crowd-sale and held in reserves. Should a seller wish the liquidated BNT in exchange for ETH, he would do so into the smart contract and receive ETH in return whereas the BNT token would subsequently be burnt.
The exchange rate is:
The larger the proportion of a particular asset held in reserves, the higher the price.
By substituting smart contract-managed reserves for the process finding a seller, Bancor creates a decentralized exchange solution that is able to circumvent the double coincidence of wants, opening up illiquid tokens for trade.
The Regulatory Landscape for DEXs
The US Bank Secrecy Act (BSA) of 1970 established extensive requirements for certain financial institution in an effort to combat money laundering. In 2013 FinCEN, the federal regulatory agency responsible for enforcing compliance with the BSA, clarified the application of BSA in the virtual currency domain.
Under the BSA, money transmitters fall into two main categories:
Administrators are engaged in the business of issuing virtual currency while having the authority to redeem such virtual currency. While certain DEXs do issue their own currency, they exert no control of the token once in circulation, making it a far stretch to classify them as administrators.
Exchangers, on the other hand, are involved in accepting and transmitting virtual currency. Since DEX’s are non-custodial, that is they do not take custody of user’s funds, it is unlikely that they would be fit the definition of exchangers for the purpose of BSA compliance.
As the scope of cryptoassets increases, trustlessly exchanging between tokenized assets will require higher levels of speed, security and interoperability. While the first generation of decentralized exchanges could not compete with their centralized counterparts in terms of speed and ease-of-use, innovative entrepreneurs are exploring the use of off-chain order books and smart contract-managed reserves as potential solutions to the exchange problem.
For many, the decentralization of cryptoasset exchange is essential infrastructure that will provide resiliency to the industry should governments attempt a heavy-handed ban as seen in China last year.