A trustless economy requires each service to be decentralized and open-sourced. Developers and entrepreneurs understand the paradigm. Price valuations, transaction volume and adoption levels have exploded for the decentralized exchange solutions currently available.
Cryptocurrencies were created as an alternative to centralized banking and payment services. The practice of requiring trust in a third party in order to gain access to an ecosystem that is trustless in nature is counterintuitive to the core philosophy of blockchain technology.
Despite the fact that most cryptocurrencies are secured by decentralized architectures, almost all trades between currencies take place on centralized exchanges. Any layer of centralization puts user funds at risk.
Decentralized exchanges (DEXs) offer true peer-to-peer exchange of cryptocurrencies without the need for intermediaries. This new evolution in technology addresses the risks associated with centralized exchanges taking custody of user assets. Leveraging open source technology (0x being one of those technologies described below) and a lack of a single point of control promote trustless transactions where third parties are not needed for facilitation. The key benefit is that users maintain full control of their assets throughout the process.
All steps in this process are open source and auditable. Transparency is key for a decentralized exchange to function. A trust in the math and technology is required versus a trust in a handful of executives working in their own interest. At no time during the transaction process are a user’s assets held by the counterparty. It is only once both sides have deposited the required amount into a smart contract that the digital assets are then
A History of Decentralized Exchanges
While decentralized exchanges succeed in eliminating third-party risk, trade-offs are made in the form of trading performance and efficiency.
As the technology matures and comes into its own, we expect to see these negative trade-offs begin to diminish.
Original decentralized exchanges – Looking back at past decentralized exchanges shows how far the technology has come in such a short time. The earliest implementations involved orders being placed directly on the blockchain. In these systems, users had to submit each transaction on-chain (buying, selling and canceling of an order). For every new order, a smart contract executed the transaction on all nodes in the network. These exchanges took up a large amount of network bandwidth and operated very slowly in comparison to the current solutions.
Automated market maker addition – Instead of on-chain order books the next concept was introduced in the form of smart contracts designed to handle market making automatically (AMM). The AMMs formulate a current price of an asset unlike a futures contract, where pricing is based on consideration at a later date. All the parties involved in the trade are filled and settled using this method, allowing for current pricing of an asset to be determined by the resulting forces of the market.
Proposed state channels – Another scaling solution that has been proposed and is actively being developed are state channels. State channels have been considered to scale the Ethereum blockchain as a whole with a goal to reduce network congestion by allowing two parties to process a transfer off-chain before committing it on-chain. For every channel, a potentially costly transaction is required to open and close it. With the current network transaction costs, these channels are most useful among known parties who want to manage a series of interactions and not a single party conducting one transaction with an open market. Below is a quote is from the 0x Protocol Whitepaper.
State channels are ideal for “bar tab” applications where numerous intermediate state changes may be accumulated off-chain before being settled by a single on-chain transaction (i.e. day trading, poker, turn-based games).
Building off the idea of state channels and automated market making smart contracts, a new hybrid protocol has been developed.
Why 0x Protocol
Decentralized exchanges (DEXs) and applications leverage the smart contracts and libraries of the open-sourced 0x project. With multiple exchanges using the same 0x protocol as their infrastructure, they create an open-standard in the exchange of value on the Ethereum network. The project supplies a base layer of infrastructure that facilitates interoperability between exchanges.
Simply put, exchanges can share their order books. For the first time the concept of a global order book can be imagined. Free of borders and geolocation, exchanges can pool their available liquidity in the form of buy and sell orders that any other exchange can pull from. As long as the exchanges use the 0x protocol, the orders are interconnected as they share the same format and can be matched with any other order from a different application.
While sharing of order books is optional, there are projects already on the market with incentives for larger exchanges to share with the smaller, and possibly newer ones. A new DEX could be created and join a global pool of orders and have nearly instant liquidity for their users. With the barrier to entry lower, new players can enter the space and create a competitive landscape, which in turn benefits the users.
The general idea behind how a decentralized exchange would work with the 0x protocol is as follows:
- A user submits a buy or sell request to the network.
- The counterparty to the request is found and signs the request digitally. A response is created in the form of a counter order.
- Both orders are sent to a smart contract that executes the transaction and transfers the digital assets to the respective wallets.
To provide the liquidity options needed to compete with the massive centralized exchanges, a hybrid of solutions is needed. This is where the state channel technology comes in play in the form of “relayers” on the network.
Third parties can create relayers that hold the entire order book of an exchange in which users send their orders to. Any party that builds a decentralized exchange on the 0x infrastructure can be referred to as a “relayer”. Each exchange controls their own individual order books (the state channel concept) with trades conducted with the series of smart contracts provided by 0x.
The benefit of shared liquidity pools is enabled by individual “relayers”. Each has the option to share with other “relayers” on the network. Incentivized with various options other than the benefit to their customers, larger exchanges can share with smaller ones.
With a truly innovative hybrid solution for the many disadvantages plaguing decentralized exchanges.