As we all know, centralized exchanges are very risky. The history showed us, more than once, the potential risk which stems from many hacks happening over the last few years. Do you remember Mt. Gox hack? Or Bitfinex? Or maybe Bitstamp? Yea, many hacks happened, and many will continue to happen.

The whole idea behind blockchain is to avoid centralization and to introduce decentralization via technology. And then, we trade those decentralized assets in a centralized place? That doesn’t make any sense and isn’t logical. It is so wrong to save decentralized assets on a centralized place during such a crucial process as trading.

Crypto community realized this issue, and started working on a decentralized exchange. Today, we have a few of them in production and a few of them in R&D phase. In this article, we will try to make an overview of what’s going on with the development of these solutions and what we can expect from them.

How do we trade our decentralized assets?

Today, when someone wants to buy some crypto asset, firstly he has to buy one kind of asset with his fiat currency. It can be Bitcoin, Ether, Ripple or some other asset that you can buy with the dollar, euro, etc. For example, you transfer the money from your bank account to Coinbase, Bitstamp, Kraken or some other crypto exchange that works with fiat currencies. After that, you have to buy Bitcoin, Ether or other asset to be able to buy some other asset in pairs btc/(asset) or eth/(asset). But, do you know where you put your money? It does not belong to you anymore since you gave it to centralized exchange, now your money is in their hands. If we go back to 2009 when Satoshi released Bitcoin whitepaper, we will see that this process goes against the goal that Bitcoin aims to reach.

Most exchanges now have Know your customer (KYC) policy, so to start trading you have to send your ID document to them. Of course, only if you are lucky and the exchange didn’t close new registrations, like many of them did. When you register on some exchange, you mostly have to wait at least a few days to get approved by the support team, sometimes even a few weeks. Unfortunately, problems don’t stop once you are in, centralized exchanges have been known to reduce withdrawal limits without warning so you can end up with valuable assets which you can withdraw only in small amounts. Besides that, they sometimes suffer from unscheduled downtime or experience other technical difficulties, and you can’t do anything about it.

Centralized exchanges sometimes act like a dictator or government, demanding high prices to get a coin listed or delist a coin because of some arbitrary reason. Also, sometimes you can’t withdraw assets because the wallet for a specific currency is being updated.

Why would I transfer my money from one centralized institution (banks) to another (crypto exchange)? And why would I hold my bitcoins there? All those exchanges are centralized, which means that I just transfer my funds from one hand to another, but I still don’t have full control over them. Of course, we can move our funds to our private wallet, but the fact that we have to make every trade without having full control of our funds is just ridiculous.

You don’t own your assets in centralized exchange

When you log in to your centralized exchange account, you can see your assets balance. You think you have your wallet with them? Wrong! That amount of BTC or some other asset that you can see, is not actually yours. Centralized exchanges are all about database management, you don’t hold any cryptocurrency. You just have a number beside your name in the database, and you can trade with that number.

That way exchange can process many orders efficiently. But, only when you withdraw crypto from centralized exchange to your private wallet, on which you have the private key, you have full control over it. This trading system requires having a lot of trust in third-party exchange, but most people don’t even trust their government or financial institutions, and now we have to trust some web service.

Just imagine, if government decides to ban crypto and conclude that all exchanges in the country are doing illegal operations. Government could freeze all their funds, a company would not be able to touch them anymore, so you would lose your funds as well. You weren’t guilty of anything. In this market where we don’t have any regulations that scenario is still possible. Long story short, the centralized exchange is the main reason of failure with crypto. It’s far away from the initial goal of a crypto ecosystem which should provide freedom from central entities.

What is a decentralized exchange?

A decentralized exchange is an exchange that does not rely on a third party service to hold user funds. The whole idea is that trading takes place directly between users, in a real peer to peer mode.

That way, the user would have full control over his funds, and he is entirely responsible if something happens. Hackers would not be able to hack into the exchange and take user funds, so trading through a decentralized exchange would be more secure and safe.

Existing work on this topic

Most decentralized exchanges are built on Ethereum blockchain, but we are not impressed with their progress. Ethereum smart contracts failed to generate significant trading volume due to their inefficient design for this purpose. Every fully decentralized exchange on this blockchain is expensive for someone who wants to trade. To be clear, it’s not expensive to make a single trade, but it’s expensive to modify order all the time depending on volatility of the market. Whenever someone modifies an order, it must be executed on smart contract and user will spend gas for that action. If user makes a few modifications and then closes the order, he will lose gas even though he didn’t make any trade.

That is the problem; it’s hard to trade in this evolving market conditions without frequently modifying orders in response to them. On top of that, since everything should be executed on the blockchain, trading consumes network bandwidth without resulting in value transfer. Some orders will result in value transfer, but there will be many more actions, like editing and canceling orders, that won’t.

Of course, that is only one approach; another alternative is using automated market maker (AMM) smart contracts.

The AMM smart contract replaces the order book with a price-adjustment model in which an asset’s spot price deterministically responds to market forces and market participants on either side of the market trade with the AMM rather than with each other. Read more at 0x whitepaper.

Although this approach makes trading always available, it has some imperfections. For example, the price for which you can sell/buy can be worse than your desired price. AMM has price-adjustment models that make trading insensitive to market liquidity. It means that trades can cause prices to move up or down according to market forces.

AMM approach is not ideal, so state channels are introduced to help scale Ethereum blockchain and reduce costs for a variety of applications on it, including exchanges. In this approach, transactions are moved off the blockchain, and any edits are made off the chain. When everything is known, the transaction will be executed on the blockchain. All sides in a state channel must pass cryptographically signed messages back and forth, accumulating intermediate state changes without publishing them to the blockchain. Channel will publish them on blockchain only when it is closed. This approach is ideal for applications where many intermediate state changes may be accumulated off-chain before being executed as a transaction on the blockchain. To get a bigger picture, we are talking about use cases like poker, day trading, turn-based games etc.

With state channels, if one participant leaves the channel or attempts to cheat, there is a challenging period of time during which one participant can send to the blockchain the last message he received from the other participant. Unfortunately, this means that both participants have to be online to agree on the trade. This approach drastically reduces the number of blockchain transactions, but it’s not cheap to open and safely close the state channel. So it’s not efficient to use this kind of service just for one-time transactions.

Motivated with state channels, some of them took a new approach that is based on the off-chain relay. This design is using broadcast, so in this approach participants that want to make an order will send it off-chain where anyone can pick it up and pass it to a smart contract for execution. With this approach only a few on-chain transactions are required to perform a trade, but still, it suffers from performance issues in comparison to centralized exchange. Also, because order matching is not automatic, there is an arbitrage risk for users who don’t manage to cancel their order in time.

Liquidity is a big challenge here

Unfortunately, problems with performance and cost are not the only one; liquidity is also a big challenge with decentralized exchanges. They still lack the commodity, ease of use and user support to be able to attract mainstream users as Coinbase did. Because of that, there is no as much capital in circulation so when someone wants to execute a significant order it’s quite possible that it won’t be fully executed, probably only a part of tokens will be sold/bought.

If they improve the liquidity that would be a great first step to encourage mainstream adoption and to get more users on it. Many factors contribute to the liquidity of an asset, but if the way in which consumers make transactions could be simplified, then we can just imagine how fast the demand for such assets would increase.

Projects working on those problems

NEX

In contrast to these approaches, recently NEX joined the game. That project aims to surpass all those problems with their system design, with which they would potentially retain all performance of centralized exchange and security of decentralized exchange. Also, they don’t want to use Ethereum blockchain; it’s the first decentralized exchange built on NEO blockchain. Personally, I like their approach, but we should be aware that they will have one system component (mapping one) that will be off-chain and will be centralized. What does it mean? If someone creates an order, the centralized part will have access to their funds but only those included in that specific trade. It’s still a trade-off between safety and performance.

WavesDEX