An A-Z guide on decentralized exchange protocols and their applications
The industry market cap for cryptocurrencies has comfortably crossed the USD 100 billion mark in June of last year. Indicating the insane amount of money flowing into this market, the world economy is surely experiencing major changes. The rise of the bitcoin and other cryptocurrencies has meant that people are sitting up and taking notice of major players in the crypto industry. Blockchain, the technology that breathes life into cryptocurrencies, is also being touted as something which could be as revolutionary as the internet in the 90s. The increase in cryptocurrency markets has led to an ever-increasing demand for exchanges, and the world has been happy to oblige. Platforms like Bitfinex and Mt. Gox have come to the rescue, and are both examples of centralized crypto exchanges.
These exchanges are fairly easy to use and have simple user designs. Data abstraction and encapsulation, two fundamental object-oriented concepts, can be seen applied in centralized exchanges too. Advanced trading functionalities such as limit orders and stop orders can also be executed through these exchanges. The registration processes are similar to any other service that you may login to or register for. A majority of the world’s traders look to utilize centralized exchanges due to their simplicity and features. The question is if centralized exchanges do the job so perfectly, why was there ever a need for decentralized ones?
Why go decentralized
The fundamental problem lying here is the fact that decentralized currency is being traded on centralized exchanges. What centralized means here is that the organization operating the exchange takes control of all transactions and funds, so, the trader has no other option but to trust the company with his/her money and details. Although centralized exchanges rule the roost in terms of popularity due to decentralized concepts being in a grey area regulation-wise, they are not true to the spirit of cryptocurrencies. Risk of fund loss or theft, a need to trust, lack of transparency and fragmentation of liquidity are a few major issues with centralized exchanges. Security remains the biggest cause for concern in centralized exchanges since when funds of a million people are stored at one place, hackers’ eyes light up. Taking down the network is easier than ever before, thanks to daily advancements in technology.
Step in decentralized exchange protocols.
Leveraging the blockchain to enable transparent and safe trading is something seemingly mastered by decentralized exchanges. Complete control of funds remains in the hands of users/traders, so there is no need to trust a third party with all your hard-earned money when you trade on a decentralized exchange. No single points of failure mean nothing less than a 51% attack on the network will take it down. Considering the security features of current decentralized exchange protocols, such an attack is extremely difficult, if not impossible, to execute. This makes decentralized exchanges true to the spirit of cryptocurrencies, which is not being dependent on a single point for operation. Therefore, no big jackpot for hackers exists in one single place. Trustless, peer-to-peer trades are executed on the network, no third parties being involved, and traders have control over their money at all times, no exceptions.
The decentralized exchange protocols
With the popularity of decentralized exchanges creeping up by each passing second, more and more money is being pumped into this sector. It is natural that the foundation for these exchanges need to be flawless if they are hoping to maintain such a large volume of money. This leads us to believe that the decentralized exchange protocols underlying these exchanges are far more important than presently considered. Similar to DApps on Ethereum, DEXs are being built on decentralized exchange protocols.
Decentralized exchange protocols are meant to facilitate a peer-to-peer exchange of cryptocurrency. The architecture of each and every one of them may or may not be significantly different than any other one. Some may constitute of closed but publically verifiable and auditable smart contract, while others may be built as open-to-all smart contracts. Still, others may build their own blockchain to create a decentralized exchange protocol. 0x, Bancor, and Bitshares are some of the most popular decentralized exchange protocols currently in use.
Applications and benefits
Decentralized exchange protocols can be viewed as having all the benefits of typical decentralized exchanges, with a few add-ons. They help in the seamless implementation of DApps since they are open standards that anyone can add to or customize as per their liking. Automatic support of new tokens is also an important feature of decentralized exchange protocols, due to the high volume of new tokens popping up all over the world every single day. They enable us to handle various situations through code rather than manually assigning personnel to address the situation.
Let us have a look at some of the popular decentralized exchange protocols currently in use.
0x is an open decentralized exchange protocol, i.e. anyone can implement and customize it to build a DEX. “Multiple off-chain limit order books, on chain execution” is what they go by. The off chain component is called a relayer and it handles storage and updates to the order book. The on chain settlement can occur in the form of makers or takers, with makers posting orders to the relayers and takers posting them to the blockchain. Execution of smart contracts validates the trade. When makers submit orders to the relayers, they do not specify any particular takers. 0x can be viewed as a system of smart contracts on the Ethereum blockchain. Currently, it is one of the most popular decentralized exchange protocols in use.
Bancor is also a smart contract-based decentralized exchange protocol. Here, the smart contract is referred to as a smart token, and the token itself does the work of the maker in the 0x protocol. Price discovery and liquidity mechanisms are a few features offered by Bancor, without requiring high volume as the traditional exchanges. The prices of the assets are calculated on-chain, using Ethereum smart contracts.
Regulatory concerns and other drawbacks
Even though the future is bright, both DEXs and decentralized exchange protocols face drawbacks in commercial use. Scalability and low throughput are some of the most commonly faced challenges, with negligible support for fiat currencies further compounding problems. Tools for fund management in decentralized exchange protocols are not fully developed, although, this and most of the drawbacks mentioned above can be overcome with time.
Whenever cryptocurrencies and the blockchain get involved, regulatory issues are bound to follow suit. The whole concept is still a fresh one, and government and federal agencies do not want to take any hasty steps which may prove to be detrimental in the future. Their cautious approach can perhaps be justified, but it is this very caution that is stunting the growth of these technologies. Only time will tell where decentralized exchange protocols take the world of crypto. Until then, let’s wait and watch!