Thursday, 20 June 2019

Decentralized Cryptocurrency Exchanges

This piece will cover what decentralized exchanges are, how they are different from centralized exchanges, and why they may be important for the cryptocurrency ecosystem.

Centralized vs. Decentralized Exchanges

Centralized exchange: A centralized exchange is a third party that matches up individuals and institutions looking to exchange with each other. The role of a centralized exchange is to reduce the friction involved in exchange by providing liquidity (“market liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable prices” — Investopedia) and convenience through an account that holds funds and positions. Stock market exchanges and the most popular cryptocurrency exchanges, like Coinbase, Binance, and Kraken, are implemented as centralized exchanges.

Decentralized exchange: Unlike centralized exchanges, decentralized exchanges aren’t coordinated by one entity. Instead, they run on a distributed ledger, like cryptocurrencies themselves do. This structure means that a decentralized exchange does not hold customers’ funds, positions, or information, and only serves as a matching and routing layer for trade orders.

Implications of Differences Between Centralized and Decentralized Exchanges

Centralized exchanges aggregate trade volume and customer account information, funds, and positions. While this is convenient for customers who can log into their account with an email and password, it also means that the exchange itself becomes a potential point of attack for bad actors. Decentralized exchanges run on a distributed ledger and do not face this risk. As explained in a recent piece about storing cryptocurrencies safely, exchanges struggle to maintain proper security, and there have been a series of high-profile hacks leading to many millions of dollars lost in cryptocurrency holdings. Because centralized exchanges aggregate so much value, they become an attractive target for hackers looking to take the funds or personal information of account holders.
Centralized exchanges can be shut down or otherwise subjected to censorship or government interference. Part of the strong appeal of cryptocurrencies is that they are beyond the reach of governments and regulators. While this certainly introduces issues related to money laundering and the facilitation of illicit purchases, it also means that an individual living in a corrupt government can truly own private property without risk of it being seized. In the traditional banking system, a government can unrightfully lay claim to the assets of an individual or group and seize them at the bank level, preventing access. Because a centralized exchange operates as a standard business with a physical location and registry with authorities, it is also liable to being unrightfully shutdown or having assets seized. This reduces the practical benefits of censorship resistance to those living under a corrupt government by limiting their ability to transact. Decentralized exchanges run on a distributed ledger and cannot be shut down or tampered with in this way.

State of Decentralized Exchanges

While decentralized exchanges offer the benefits of anonymity, freedom from censorship and security, there are many practical challenges they must overcome before they can compete with centralized exchanges. Here are a few shortcomings that decentralized exchanges face for the time being:

Difficult to use: One reason that centralized exchanges like Coinbase have become so popular is that they make participating in the cryptocurrency market simple. Users are provided with an email and password combination and do not need to worry about managing their private keys. At the moment, decentralized exchanges lack a simple user interface and user experience which limits their reach.
Limited functionality: Decentralized exchanges offer limited functionality compared to centralized exchanges. This is usually a limitation in order type (no stop loss or limit order available) or lack of breadth of coins to trade (due to lack of trade volume, discussed below).
Low volume trade volume: Because of the previous two shortcomings of decentralized exchanges (difficult to use, limited functionality), there is low transaction volume which means that it may be hard to find a counter-party for a trade.
Current Decentralized Exchange Projects
There are many projects in the decentralized exchange space, but here I will profile three: 0x Protocol, Airswap, and OmiseGO.

0x Protocol

As described in the 0x white paper, “we describe a protocol that facilitates low friction peer-to-peer exchange of ERC20 tokens on the Ethereum blockchain. The protocol is intended to serve as an open standard and common building block, driving interoperability among decentralized applications (dApps) that incorporate exchange functionality. Trades are executed by a system of Ethereum smart contracts that are publicly accessible, free to use and that any dApp can hook into. DApps built on top of the protocol can access public liquidity pools or create their own liquidity pool and charge transaction fees on the resulting volume.” 0x provides a backbone to exchange ERC20 tokens.


As detailed in the Airswap white paper, “we present a peer-to-peer methodology for trading ERC20 tokens on the Ethereum blockchain. First, we outline the limitations of blockchain order books and offer a strong alternative in peer-to-peer token trading: off-chain negotiation and on-chain settlement. We then describe a protocol through which parties are able to signal to others their intent to trade tokens. Once connected, counterparties freely communicate prices and transmit orders among themselves. During this process, parties may request prices from an independent third party oracle to verify accuracy. Finally, we present an Ethereum smart contract to fill orders on the Ethereum blockchain.” Airswap is a Consensys project and is similar to 0x in many ways except that trades on Airswap are negotiated off chain while 0x matches orders through relayers.


As explained by the OmiseGO white paper, “OmiseGO is building a decentralized exchange, liquidity provider mechanism, clearinghouse messaging network, and asset-backed blockchain gateway. OmiseGO is not owned by any single one party. Instead, it is an open distributed network of validators which enforce behavior of all participants. It uses the mechanism of a protocol token to create a proof-of-stake blockchain to enable enforcement of market activity amongst participants. This high-performant distributed network enforces exchange across asset classes, from fiat-backed issuers to fully decentralized blockchain tokens (ERC-20 style and native cryptocurrencies). Unlike nearly all other decentralized exchange platforms, this allows for decentralized exchange of other blockchains and between multiple blockchains directly without a trusted gateway token.” OmiseGO is highly ambitious and is attempting to build a decentralized exchange that allows for transaction in any currency.


For now, decentralized exchanges offer great promise but cannot offer the functionality that centralized exchanges can. It will be interesting to see how these projects develop and what impact they have on the cryptocurrency ecosystem.

By Phil Glazer

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