What is a Decentralized Exchange

– Let’s talk about decentralized exchanges.

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In recent months there’s been an absolute explosion  of new tokens hitting the cryptocurrency market.  These tokens are predominately linked to ICOs  or Initial Coin Offerings that are happening  and as a result, a lot of people out there  are looking for liquidity of those tokens  that they’re purchasing.  Now, as this was all new, things were going pretty smoothly  the last few months with exchanges like Bittrex  and Poloniex pretty quickly listing these tokens  just a week or two after the token sales.

To those unaware, Bittrex and Poloniex are centralized  exchanges similar to the stock exchange, but you can  trade crypto assets, so token A for token B, or token A  to Bitcoin or Ethereum.  So, things were going smoothly, but more recently  with looming SEC regulation and unclear guidelines  on what constitutes a security, these exchanges  have been a little bit spooked and they aren’t listing  ICO tokens as quickly as they were previously.  A good example of this is is that Bittrex haven’t  actually listed an ICO token as of early August  at the time of filming.

So, people are slowly starting to panic  that they might not be able to sell these  ICO tokens any longer on these exchanges.  So, they’ve become essentially, non-liquid.  In addition, centralized exchanges just have a pretty bad  history in terms of security.  When you’re trusting an exchange like Bittrex, Poloniex,  Coinbase, whatever, you’re trusting them to hold  all of your funds and very often they don’t give you  the private keys to access them.

A simple Google search would show you the bad history  we have here, but if you look at examples  such as Mt. Gox and Cryptsy, there’s definitely  a precedent for centralized exchanges not being  a very alluring or secure place to store your tokens.  You really wanna get your tokens in and out  of centralized exchanges as quickly as possible  to reduce the risk of them getting hacked  and your losing everything.  Decentralized Exchanges aren’t a new concept.  The topic has been around for a while and they’ve  actually been possible for quite a while thanks  to Ethereum and Smart Contracts.  They’ve also been possible on Bitcoin using something  called a Hashed Timelock Contract.

The adoption of this option has been low.  Now that more and more people are getting familiar  with coding Smart Contracts on Ethereum combined  with a rush of tokens that suddenly need to be traded,  is kind of a very good product market fit there  for this decentralized exchange technology.  So, today I’m gonna cover some of the big players  coming down the pipeline as it relates  to decentralized exchanges.

I wanna preface this by saying, yes, I am aware  that there are decentralized exchanges that exist  on other blockchains such as Waves.  I’m not gonna cover those today because most of the volume  demand in terms of the trading tokens today  is around ERC20 tokens, which are Ethereum based.  So, I’m just gonna focus on decentralized exchanges  in the Ethereum space for this video.


The first I’m gonna cover is the decentralized exchange  called EtherDelta.  EtherDelta has actually been around for awhile.  It was one of the first Ethereum based  decentralized exchanges.  That’s been around since last year and it’s currently  active, so you can go and trade on it today.  All of the funds on the EtherDelta exchange  are handled by this unified Smart Contract.  So, that means when you wanna trade something  you send those tokens into this Smart Contract  address on the Ethereum network.  This has a couple of benefits that people like.

Namely, you don’t have to register for anything,  but secondly, you’re also not trusting a centralized  server or company with your tokens.  You’re simply putting them over into the EtherDelta  contract and you can pull them out at any time.  So, that whole risk I was talking about  with centralized exchanges getting hacked, goes away.  This is gonna be a pretty common paradigm that’ll  apply across all the technologies I’m talking about today.  The whole security aspect is taken care of  because of Smart Contracts.

There’s no sending your funds to a company like Coinbase  or Bittrex who could run off with them or get hacked.  This is just kind of a stock standard expectation  of decentralized exchanges.  It’s not a special feature and it doesn’t really  set any of them apart. What’s going to set the platforms I’m talking about today  apart is how they manage orders and facilitate trades  between buyers and sellers.  One of the tenants of EtherDelta is they try to keep  as much of the trading on chain, and by that I mean  they wanna keep most of this trustless and in the  Ethereum blockchain which means that whenever an order  is executed and settled, it’s all happening in an Ethereum  block and it’s immutable stored in a blockchain.

One of the challenges that these decentralized exchanges  face though, is that Ethereum blocks aren’t mined fast  enough for high frequency trading.  So, as such, EtherDelta actually has a semi-centralized  service for an offchain order book.  When you, as a buyer or seller on EtherDelta,  want to submit an order you sign a message.  You don’t submit it to the blockchain, and then that gets  stored in this offchain solution that EtherDelta has  to replace an order book.

If you’ve ever tried to use EtherDelta you’ve probably  been pretty confused, because it doesn’t function  like a regular exchange.  This stems from the fact that EtherDelta only supports  what are called resting orders.  There is no automatic matching between buy and sell orders.  So, if you’ve used a traditional exchange like Bittrex,  you’re probably used to setting up a sell order and you  say you wanna sell X many number of tokens, then you  can kind of set and forget it and the automatic trading  engine will match your sell order with a buyer once  the price reaches what you wanted to sell at  and everything will be filled.

EtherDelta, and decentralized exchanges in general,  don’t work this way.  Instead, everything is manual.  So, when you place a sell order it won’t be picked up  unless a human on the other end of the equation manually  clicks that sell order and says, yes, I wanna buy that up.  Inversely, if you set a buy order, it won’t automatically  be filled either.  A seller has to click your buyer order in the EtherDelta  order book to then fulfill that order.  This is kind of clunky and it has all sorts of impacts  on liquidity and the way that the order book balances out.

For a person who’s familiar with using traditional  exchanges, be it Bittrex or Coinbase or even the actual  stock exchange and things like Etrade, it’s very, very  different and because EtherDelta has this centralized  relayer for its order book, which happens offchain,  but then the trades are actually settled onchain  once somebody picks up a seller or buyer order.  This often gets out of sync and things get slow.  So, there’s actually a chance that when you say, yes,  I wanna buy this sell order on EtherDelta, somebody else  might’ve already fulfilled that.

Your order will fail when you actually pay the cost  and submit it to the blockchain.  This problem matched with the fact that everything’s  onchain actually makes trading on something like  EtherDelta pretty expensive because remember, every  transaction on Ethereum right now costs upwards  of 20 to 30 cents and if you’re submitting a bunch of orders  that only have a 50/50 chance of actually being picked up  because somebody might have already filled them, there’s  a good chance you’re literally throwing money away.

And, because of the lack of automatic matching there’s  all sorts of arbitrage opportunities that happen  where stale orders can be picked up and manipulated.  It’s just not fun.  Now, with something like EtherDelta, you can cancel orders  once you’ve submitted them, but this actually opens  another risk, which is called front running.  And, the simplest explanation of this is that because all  the trades are being settled onchain, miners of Ethereum  have full visibility into them.

So, if you submitted an order on EtherDelta yesterday,  but today it’s actually not a really good deal  and you wanna cancel it, because you signed that order  initially, a miner could still actually execute it.  That’s called front running, and be the counter party  on the other end, so you lose money and the miners  make more money because they’re executing  your canceled orders.  So, EtherDelta is far from perfect, but it’s an interesting  experiment and it’s out there and working today  which is more than can be said for a lot of the protocols.  As I said, there’s a lot more development taking place  and a lotta protocols coming through the pipeline.


So, next in line is a protocol called 0X.  0X is actually a lot like EtherDelta in the way  that it works.  They didn’t ICO though, so they have a token  called ZRX and they claim that they’re gonna use  this token for the fees and decentralized governance.  As I said, that’s very similar to EtherDelta in that  it uses an offchain relay system to match makers  with the buyers and takers with the sellers  for filling those orders offchain.  It then does all the settlement onchain and it calls this  a hybrid approach.

The difference with 0X is that unlike EtherDelta  which has the EtherDelta owned order book relayer system,  which is just one, 0X, anybody can spin up a relayer  and become a relayer themselves.  As a relayer you get paid transaction fees for matching  buyers and sellers.  It’s similar to mining in a way, but you’re matching up  people that wanna trade different tokens.  It’s important to outline that 0X is actually  just a protocol.  It is not necessarily a company that is  offering the exchange.  Using the protocol, other companies can spin off their  own decentralized exchanges on top of it.

There’s one that actually just came out recently  called Radar Relay.  Just like EtherDelta, because it’s using these  resting orders in the system, it doesn’t have  any automatic matching, it’s kinda confusing  and it’s just not as nice to use as a centralized  exchange is today  0X is subject to most of the same problems I identified  with EtherDelta, so I’m not gonna rehash them here.  It also actually opens up a few other attack factors  because of its ability to allow anybody  to be a relayer in this equation.

Something that EtherDelta does is it only supports  something called broadcast transactions.  I broadcast my order out there and hope that it gets  relayed to somebody and that relayer is essential  to that trade taking place.  0X also supports broadcast trades, but it also supports  something called point to point trades.  Point to point trades are essentially the same, but it means  that you can bypass the need for a relayer.  A buyer and seller can negotiate offline, come  to an agreement without having to go through a relayer  to facilitate that transaction.

This is appealing to buyers and sellers ’cause it means  that you can forego having to pay a transaction fee  to do the trade.  The problem here is there is a gaming vector whereby,  a buyer puts in an order and submits it to a relayer  and a relayer matches them up with somebody, but at the last  minute the buyer cancels that order and just facilitates  the trade offline with the seller.  In this case the relayer has done the work of matching  these two people and so by working offline together  they’re able to bypass the relayer who did the work  and not have to pay them the fee.  So, the relayer ends up out of pocket.

If this gets exploited enough it could become  less enticing for people to become relayers  ’cause they could just be doing all this work  and losing the transaction fees which could ultimately  result in a lack of relayers and problems matching  buyers and sellers together.  Without a broad network of relayers it becomes a lot like  EtherDelta with just a centralized bunch of people  relaying between the buyers and sellers.  There is also an attack vector called maker griefing.  A maker is just a buyer.

This involves a buyer placing an order, but then  at the very last minute, moving the funds out of their  account that were associated with that order,  the funds they were going to trade.  The network and the Smart Contract will attempt  to settle that order onchain, but because the funds  aren’t there anymore it will fail.  The side effect is that the miners still get the gas cost  associated with processing that Smart Contract  and if you look at the protocol of people that are paying  those fees are the takers, or the person that’s  doing the sell, so the attack here is that a bunch  of Ethereum miners could collude, submit a bunch  and a bunch of bogus orders for buys and then  move the funds at the very last minute.

Those miners would then collect all the gas costs  that the takers were putting up, but the trades  would fail and the Ethereum miners wouldn’t actually  transfer the tokens.  This would obviously involve a bunch of malicious miners  doing this, but you know, anything’s possible in crypto.  So, in both EtherDelta and 0X protocol, there is still  an order book.  It’s simply being relayed and communicated  by these relayers, be they centralized or decentralized  in the case of 0X.  As a reaction to this, some people are saying,  you know what?  Order books are outdated, they don’t apply to crypto.


Let’s come up with a better approach.  This is exactly what a project called KyberNetwork is doing.  If you have ever used the server ShapeShift or IO  which lets you send one token in and get another token out  anonymously, think of KyberNetwork as essentially  the ShapeShift of decentralized exchanges.  In Kyber the buyers know the conversion rate  before they send their money across.  They know what to expect in token B when they send  through a bunch of token A ahead of time.

And the whole promise here is because they’re aren’t  relayers users don’t have to pay any other transaction fees  other than the gas costs of sending into  the Smart Contract of Kyber.  Instead of maintaining an order book, Kyber has something  called reserves, and these are essentially just large  stores of tokens that can easily be liquidated  and sold to somebody.  The administrators of the KyberNetwork are able  to list and de-list different types of tokens,  so they choose what tokens are tradable through  the contract and in addition to that, they’re also able  to choose who is allowed to be a reserve on the network.

To become a reserve operator you actually have to go through  a KYC process with Kyber, which is kind of interesting.  I’m not sure of the implications of that will be,  if people will wanna do that.  But, once you’ve set up a reserve people can then contribute  to it and then become reserve contributors.  These people essentially become the sellers in the exchange.  So, a reserve operator will go out and set up one  of these reserves and a bunch of people will contribute  their money in, in the hope that they’ll make a profit  when that eventually gets sold.

The interesting thing here is that the price that the tokens  are then traded at is completely set  by the reserve operator.  So, the reserve operator is in complete control  of monitoring the market and having to set the price  when it updates over time.  This, to me, feels a little bit tricky because markets  fluctuate like crazy in crypto and the price can go  up and down in a matter of minutes.  The reserve operator is gonna have to be pretty responsive  in terms of updating the prices when things change.

Back to the way that this thing works, once you have these  reserves set up, there’s a big bunch of liquidity basically.  The buyers come in and say, I wanna buy 1000 of token B  The Kyber Smart Contract then goes out and finds  the reserve with the best price that you can get  for token B.  It might say it’ll cost you one token A per 1000 token B.  If the liquidity exists on the reserve side,  if the buyer accepts the offer from the reserve  at a certain price, the whole thing is executed  in a Smart Contract, the tokens trade hands  on the Smart Contract and everything is secure.

Any profits that are made by the reserve on that sale  then get distributed evenly across the people  that contributed to that reserve and gave it its liquidity  in the first place.  Again, this is really, really different to a typical  centralized exchange, because as a buyer, you don’t have  a lot of control.  You basically have to agree to whatever the reserve  operators are setting as the price.  The kind of theory here is that the reserves, because there  will hopefully be many of them, will be competing  to provide the best price possible and this market  will bring down the price to something that’s equal  to what you’d see on other exchanges.

This obviously, needs to be tested in practice,  but it seems like a pretty simple approach ’cause it’s  the most like ShapeShift and maybe that’s a familiar  paradigm that people will buy into.  I have some concerns.  Firstly, the reserve operators setting the price.  If they’re not quick enough that could potentially result  in arbitrage opportunities between KyberNetwork  and centralized exchanges or other decentralized exchanges.  Another thing that the KyberNetwork team haven’t been  fully transparent on is how long they’re gonna require  people that are putting funds into a reserve  to hold them there.

That could actually result in a liquidity issue  for the people that are contributing to the reserves  or the reserve operators because their funds can’t  be moved out of the Smart Contract.  Kyber seems to be running on the testnet.  We’ll have to see what happens once they hit MainNet.  Like most of these projects Kyber is also running  a token sale.  I believe that their token will give you some sort  of membership access to the ability to even trade  on the platform.  It’s kind of like paying an account fee up front  with a certain token.


Another protocol that’s doing away with the order book  is called swap. You may have heard of the referred to as, air swap,  which is their for profit company that is building  a platform on top of the protocol.  The best way to think about swap is kind of like  a marketplace.  You have a bunch of buyers and sellers walking around  trying to negotiate to come up with the best deal  for both parties.  Similar to EtherDelta and 0X, the swap team have realized  that it’s simply too inefficient to do any of this stuff  onchain except the trade settlement.  So, they’re still doing the final order settlement onchain.

Could all the matching of buyers and sellers  and negotiations happening offchain and because there’s  no order book it actually means that this stuff  is happening privately.  It’s kind of anonymous in that nobody’s able to see  your negotiations taking place like they are  when there is an order book like 0X or EtherDelta.  The swap protocol has a peer protocol built in  with something called offchain indexes, and these indexes  simply aggregate all the orders out there on the buy  and the sell side and then match buyers to sellers  and vice versa.

So, an example workflow for this is that a buyer comes  in to a swap protocol enabled app and they say,  I wanna buy 100 of token B and I wanna buy it with token A.  At this point they aren’t specifying the exchange rate.  They submit this offchain via the peer to peer protocol  to an indexer, who then goes and finds the seller  who wants to sell some token B and get token A in exchange.  Those two parties then need to come together, again offchain  privately, and negotiate a price which they’d both  be willing to make the trade.

The obvious question here is, how does the price get set?  And, the swap protocol specifies something called an oracle.  And, the oracle looks across the current network  and determines what the recommended market price is  for people switching token B to token A.  So, both the buyer and the seller in this equation,  when they’re doing this offchain negotiation can consult  with the oracle and then change the price that they’re  requesting based on the recommendation the oracle gave them.  Once they come to an agreement, the price they’re willing  to trade at, the order then finally gets executed onchain.

And, the swap takes place.  By doing the bulk of this stuff offchain through this  peer to peer protocol, they’re reducing the inefficiencies  and making it a lot faster, but they’re also reducing  the gas cost considerably, because the only time you  ever have to do anything onchain is when the order is sold.  And, because all of the negotiation is happening offchain,  it avoids the problem that we talked about earlier,  front running, because miners have no visibility  into these private communications that are happening  and these private negotiations between a buyer and a seller.  There’s no way a miner could come in and potentially  mess with that.

This means that ultimately buyers and sellers get  a very fair trading experience.  Now, that’s not to say that this swap protocol doesn’t  have some potential drawbacks that I’ve identified. Firstly, out of the box, there’s no automation  so you can’t set buy orders or sell orders  that get executed automatically.  And, my second concern is about that oracle service.  Is there a way that that oracle can be gamed in any way  to wildly fluctuate the price that it’s recommending,  to then push trades that people are negotiating  in certain directions? Now, I’m only going off what I’ve seen in the White Paper,  but I haven’t seen anything about how they would mitigate  attack vectors with influencing the oracle through  submitting a whole bunch of bogus orders  with ridiculous prices.

Omega One

Now, the last technology that I wanna mention  and I think it’s worth a mention, is Omega One.  It’s not necessarily a decentralized exchange per se,  but it exhibits multiple traits of one with security,  but gives you the speed and efficiency  of a centralized exchange.  Just like all the other protocols I’ve mentioned today,  Omega One stores your funds in a Smart Contract  so there’s no way that they can be stolen.  You’re not relying on a centralized authority.  The only time you do anything onchain is when you’re  settling an order and the swap is taking place.

But, let’s talk about what makes Omega One different.  It consists of two components.  The first is an internal trading pool.  So, it’s similar to other protocols in that it has this  internal network and if buyers and sellers in there  are wanting to trade the same thing and it can adequately  match a buyer with a seller, then it will  do the swap internally.

So, if you wanna buy a bunch of token B for token A  and there’s a seller on the other side of that that’s  also on the Omega One network, then the protocol  will match you two together and trade you  in the middle of the market.  But, if that liquidity doesn’t exist which is often the case  with these smaller decentralized exchanges, there isn’t  a buyer on the other end of your sell order, or there  isn’t a seller who’s willing to sell you as much  of token B that you want, Omega One as a platform  actually goes off to multiple centralized exchanges  and trades on your behalf to get you  the best price available.  So, it’s going out when it can’t find liquidity  and finding more liquidity in these centralized exchanges.

The real cool thing I see about Omega One is that you  get all the benefits of the decentralized exchange.  You get that security that’s backed by a Smart Contract  and you also get the ability for that internal trading pool  to efficiently route buyers and sellers towards one another,  but you also get the cost and time efficiency of  a centralized exchange, plus the liquidity if it doesn’t  exist on the internal network.  Omega One have really gone for the best of both worlds  approach here, where they’ve kind of found a good  middle ground and I think it’s really interesting.

One of the challenges it’s gonna face is that if you’re  going off to liquidity and the token isn’t listed  on one of those centralized exchanges, as I mentioned,  Bittrex and Poloniex, they aren’t listing a lot  of tokens anymore.  If it’s not listed, then Omega One’s gonna have  a hard time finding it because it’s not gonna be  on those centralized exchanges.  My guess is that the internal pool will probably take  care of that because the token will be listed there.  The volume and the liquidity might just be a lot smaller  than it would be on one of these centralized exchanges.

Like everybody else these days, Omega One is doing  a token sale and I believe that’s gonna give you  access to membership and again, your account fee  to be able to trade on the network.  So, that’s a rundown of some of the technologies  coming through the pipeline and I’m sure we’ll see  them hitting the MainNet sometime over the next six months.  I think these technologies are really cool, but it’s gonna  take a while to perfect them and when you go to the real  polar end of the spectrum in terms of decentralization,  it’s just too inefficient.

I think they are gonna need to be stepping stones, where we  accept a little bit of centralization and then  a little bit less and a little bit less, to get  to a fully decentralized exchange.  Otherwise, it’s not gonna be cost effective and it’s not  gonna be fast to use.  And, those are the things I think most people  have come to expect out of an exchange  as just a base level of service.  A common theme I was bringing up in this breakdown  is that all of these protocols are storing your funds  in a Smart Contract on Ethereum as a way of securing it  and you not having to store it with a centralized  authority or company.

Now, while this is more secure, you’re putting a lot  of trust in the Smart Contracts themselves, and I would say  the majority of people out there that are trading crypto  assets probably aren’t capable of auditing  a Smart Contract fully.  Flaws in Smart Contracts are not unheard of at all  with the Dow hack, the Parity multi-sig wallet problem.  Tens of millions of dollars have been lost in Ethereum  due to bad Smart Contracts.  So, one speed bump that I think decentralized exchanges  will face inevitably at some point in the future  is bad Smart Contract coding resulting in the loss  of user funds at some point.

When you’re running a huge amount of money in liquidity  through a Smart Contract, it essentially paints  a big red target on it for hackers to go and try  and find vulnerabilities and exploit them.  Another problem facing some of these protocols is  that they currently only support Ethereum.  They only support a single blockchain.  And, while technology such as Kyber have been talking  about cross chain atomic swaps with something  like Bitcoin, this is really far in the future  and I don’t think it’s something we’re gonna see  this year or maybe even in the first half of next year.

The technology needs to be proven out.  I imagine Omega One might be able to get past this  because it’s sourcing some of its liquidity from centralized  exchanges, so it will be able to do, I think, cross chain.  And lastly, because most of these exchange protocols  I’ve described kind of involved a shift in paradigms  of how people are used to interacting with exchanges,  then I think there’s gonna be some inertia towards  the traditional centralized exchanges and it’s gonna be  harder to pull users over, especially if these  decentralized exchanges are more costly or slower  to use up front.

The benefits of using decentralized exchanges have  to quickly outweigh that of centralized exchanges  in order to shift the bulk of traders over from centralized  to decentralized and build enough liquidity pull,  so that it’s worthwhile going and trading on them.  If there’s a load of liquidity in these markets  I just think it’s a real barrier to their success.  So, that’s my breakdown of decentralized exchanges.  There’s a lot coming in the works.

I think we’re still in the very early days and it’s  probably gonna be a good six to 12 months before we  see one that’s reliable and you can use  on a daily basis.  I hope you found this video useful.  If you have any questions, just drop them  in the comments below.  I’d also love to hear about any other decentralized  exchanges I didn’t mention.  Let me know.  There’s some coming on the market every week, I feel.  Thanks for watching.  Until next time, see you later.

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What is a Decentralized Exchange