While this could turn out to be the year of the Dex what is certain is that the age of the Dex is dawning.
2018 is being touted as the year of the decentralised exchange (Dex). This is not to be doubted with the speed at which the entire industry is plugging away at innovation and bringing about more and more disruptive technologies. Dexes are one of the products of this movement and the future is exciting.
If you’re like me you’ve considered cashing out of fiat for some cryptocurrency. But maybe you didn’t want to deal with the headache of account verifications and jumping through hoops just to see what all the bitcoin buzz is about. Fortunately with Dexes those issues might all but disappear.
Maybe you’ve thought about selling on eBay but the seller’s costs are too high to make a profit. That is a genuine barrier to doing business and also makes what you buy more expensive. Of course if there was an alternative that provided no fees whatsoever your eyes might pop. With Dexes that is not possible in the future but is a reality today.
The barriers to using cryptocurrencies are disappearing before our eyes but to get full benefit understanding what Dexes are and what they do is important. This article lays out the definition of a Dex, the need for Dexes, the different kinds of Dex and what they bring to the table for you, the user.
Why is there a need for Dexes
Centralised exchanges have numerous shortcomings. The most important is security for user funds. In 2014 the infamous Mt Gox attack occurred. With centralised exchanges user funds are pooled in exchange wallets. Fully custodial cryptocurrency exchanges are useful for market entrants wetting their toes in the market. The trouble is this centralisation of user funds is a risk that will always be present.
The Japan-based cryptocurrency exchange was forced to cease operations after US$400 million dollars was stolen by hacking the exchange’s wallet. The Mt Gox hack is a defining reason for Dexes to spring into existence. It is reported that since the Mt Gox hack there have been another nine attacks on centralised exchanges.
Another issue with traders is the risk of a practice known as front running. Front running refers to automated trade on an exchange either by the exchange itself or other traders. These malicious types of trading act faster and fill orders at prices which result in price movements above or below an expected entry price.
For some users under oppressive state regimes privacy is an important concern. With centralised exchanges who have localised servers there has been a push from governments around the world for closer regulation. This leads to more stringent know-your-customer and anti-money laundering laws.
What is a Dex?
Defining a decentralised exchange is no easy task. Defining decentralisation perse is a difficult task. Nathan Sexer, chief communications officer at Variabl defines a decentralised exchange as follows (emphasis added):
‘decentralized exchanges differ from centralized exchanges as they enable users to remain in control of their funds by operating their critical functions on the blockchain... It solves the main limitations faced by cryptocurrency markets, since there is no single point of failure, aligning them with what has made the blockchain technology so powerful in the first place’.
Phil Glazer, writing in HackerNoon, defines a Dex by saying that ‘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’.
Both definitions serve a purpose. The trouble is that these definitions ignore the existence of crypto-to-fiat decentralised exchanges. This causes problems. A Dex like Bisq operates in conjunction with the various blockchains listed on its order books. However, fiat currencies are yet to be instituted on the blockchain. To facilitate that trade, Bisq uses an escrow system.
Another problem is that these definitions seem to ignore node structure in a decentralised network. For example, looking at the 0x protocol, its native blockchain incentivises bookmakers to act as transaction validators which is essentially the function of a node on a decentralised cryptocurrency network. The 0x protocol is setup for the unfinalised Proof of Stake (PoS) protocol to be made to the Ethereum blockchain.
0x has its own native blockchain token, ZRX, but the 0x protocol only interfaces with other blockchains as it validates transactions between buyers and sellers. It is worth remembering that a bitcoin maximalist would have serious doubts about whether PoS is even decentralised because it is understood to be a move away from bitcoin’s node consensus model.
Throwing the proverbial hat in the ring, this article defines a Dex as being: a distributed network of nodes operating for the validation of order books achieving consensus per exchange requirements, which can otherwise be called a decentralised autonomous network. Having no single point of failure, a Dex facilitates the transfer of value denominated in cryptocurrency or fiat between market maker and market taker.
The three kinds of Dex
- Cross chain Dexes
Cross chain Dexes transact from one blockchain to another. For example, trading Ethereum for bitcoin. This is done in two ways. Either by using a escrow system like the Bisq exchange or by utilising cross-chain atomic swaps like Baterdex. Several others like Komodo are still in development and testing phases.
- Token to token Dexes
Binance is a purely token to token Dex. There is really only one type of token to token dex, which consists of a smart contract that executes trades automatically and completely trustless. 0x is an example of this kind of Dex. EtherDelta and many others find it easy to trade across ERC20 tokens based on the Ethereum blockchain.
- Fiat to cryptocurrency Dexes
Coinbase, for example is not a Dex. The reason for this is that user funds can be pooled in potentially vulnerable wallets. However it is one of the primary channels for on-ramping fiat currency to cryptocurrency. It is important to note that trading between cryptocurrencies on exchanges is a relatively straight forward process.
For Binance, which is solely for the trade of crypto to crypto, establishing a Dex based on that model will not be hard. However, this has nothing to do with a fiat currency holder who is looking to exchange that money into cryptocurrency. For widespread adoption of cryptocurrencies one of the biggest challenges is the on-ramp problem of transferring wealth from fiat into cryptocurrency.
What Dexes bring to the table
One of the major criticisms of Dexes is their low trade volume. Due to the early stage that the entire industry is at Dexes have severe limitations in a business sense. Atomic swaps are not reliable at the time of writing. What this means is that liquidity in the dexes market is low. Even 0x which capitalises on the efficiency of the Ethereum blockchain will struggle with low trade volumes.
Even though liquidity is an issue with Dexes It has become clear that the shift in market is approaching. The recent Binance announcement of a Dex protocol development is hard to understate. What the announcement shows is that not only is the demand for dexes there but it is necessary for the survival of exchanges to implement some form of decentralisation.
In a sense that means that Binance is bringing liquidity to the Dex market and will lift the user participation in Dexes. For cryptocurrency traders it will mean fairer trading, lower fees and greater ability to maintain privacy. For those already positioned in the cryptocurrency market this will be a huge advantage. In addition to that, when atomic swaps are workable cryptocurrency trading could rocket to the moon.
Dexes will make it easier to exchange fiat currencies for cryptocurrencies. In 2017 the value amount of money in the global cryptocurrency market went from below US$18 billion to over US$600 according to CoinMarketCap. Whether that exponential increase continues is uncertain but cryptocurrency is the world’s payments future and migrating fiat to crypto could be big business.
eBay as a Dex
OpenBazaar is one of the most interesting concepts in commerce today. Its platform brings buyers and sellers together without any fees. It is not specifically a cryptocurrency exchange but more like a decentralised version of eBay where you can spend cryptocurrencies. The technical structure of the commerce platform is secure although questions around the security of its built-in wallet do exist.
Dexes like OpenBazaar have very low or no regulatory costs associated with doing business. Dexes like OpenBazaar have the potential to be disruptive and threatening to established internet commerce providers like Amazon or eBay. Similar to other Dexes, OpenBazaar will struggle at first with liquidity. The number of buyers and sellers is low and trade is conducted exclusively in cryptocurrency.
The amazing element here is that OpenBazaar is a platform that allows users to transact on a peer-to-peer basis. For those well versed in the writings of Satoshi Nakamoto that was the vision of bitcoin. This is a direct consequence of the bitcoin whitepaper and it seems irreversible. How can a free marketplace be beaten?
There is little doubt that Dexes are the way of the future and could completely replace centralised commerce platforms altogether. In effect, Dexes could make household names like Amazon and eBay obsolete. Either way the future of commerce, finance and cryptocurrency trading is going through an incredible period of change… Watch this space.