Problems Facing Decentralized Exchange

Frontrunning: Decentralized exchanges still need some mechanism (whether third-party or code) to match buyers and sellers. There needs to be a trustless mechanism to prevent a third-party from looking at unconfirmed orders and undercutting them to make easy profits. One possible solution 0x is exploring is a semi-decentralized trade execution coordinator.

Fragmented Markets: Since decentralized exchanges typically aim to have less structure and more freedom, buyers and sellers will be more fragmented and network effects will be less beneficial for growth rates. Separating markets into too many pricing pairs with different exchange rates and liquidity pools would magnify this. This could affect Kyber, OmiseGO, and Bancor’s liquidity network approaches.

Also, if projects on the same DEX protocol have their own siloed sets of buyers and sellers (as with 0x and their “relayers”), total protocol growth would likely be slower. 0x is currently attempting to have relayers share liquidity via an API, but it is uncertain if a significant portion of the relayers will adopt it.

For reference, NASDAQ and NYSE markets see respective daily trading volumes of $130.6 billion and $55.3 billion, while Binance (the 3rd largest cryptocurrency exchange) experiences daily trading volume of $1.4 billion, and the total DEX sector has daily trading volume of roughly $25 million. (Trade volume statistics from nasdaqtrader.com, nyxdata.com, and coinmarketcap.com as of 8/1/18.)

Atomic Swaps: Partly due to technological constraints of the blockchain, decentralized exchanges need to build out atomic swaps that switch a buyer and seller’s assets cross-chain when their orders have the exact same preferences. This lowers fees and increases transaction speeds. Many of the decentralized exchanges are developing and testing this technology currently, as interoperability has become a major emphasis.

KYC/AML: As the SEC begins to regulate the crypto industry, the most logical point of regulation comes down on exchanges, requiring tracking of who enters the space and how much their holdings are. Exchanges in the space will need to get better at conducting KYC/AML. For decentralized exchanges, this will likely involve a protocol layer that verifies user identity before allowing them to join the exchange and blacklisting addresses for bad actors or non-accredited investors when applicable.

# of Exchange Rates: Exchanges are currently attempting to figure out how to allow users to exchange any token for another without needing to first sell a token for BTC and then use BTC to buy the other token. Requiring sale to BTC can delay transaction speed and increase fees, while allowing direct sale between all tokens would create too many pricing pairs to be an efficient exchange. Bancor Network is solving this with “smart tokens,” which offer market liquidity for any token with a single price in USD. This is made possible via a number of smart contracts that store market liquidity and allow users to move from one token to another.

Trade Collisions: The blockchain functions by grouping transactions into “blocks” and processing them. For many protocols, this occurs about every 5–10 seconds. If two individuals submit the exact same order within 5–10 seconds of each other, the transactions would enter the same block, both users would have to pay transaction fees, but only one of the transactions would go through. This is called a trade collision and as the size of markets increases, without a solution, this will occur more frequently and result in higher fees for users. There are a few approaches for DEXs to limit or prevent trade collisions that we will explore in Part 2, along with analyses on specific DEX projects and our personal investment outlook.