A review of decentralized solutions for crypto liquidity

By: Alan Keegan and Alex Gordon-Brander

Crypto markets have two huge problems — liquidity and trust. As anyone who has ever tried to trade crypto in size knows, trading between different crypto assets is prohibitively expensive due to the frictional “liquidity cost” of those trades moving the market, while hacking has led to the theft of $5bn of crypto assets at current prices. These two issues prevent the inflow of the institutional money that is required for the maturity of the ecosystem, as those investors require liquid markets and low counterparty risk.

2017 has seen the emergence of a new class of decentralized and partially decentralized solutions that solve the issue of counterparty risk, allowing for non-custodial trading and settlement. This is key to institutional adoption, as leaving customer funds on a custodial exchange requires a high bar of trust that might take years of perfect stewardship before proving worthy of holding a pension fund’s money, while any non-custodial liquidity solution can offer zero counterparty risk. In the race to solve the two needs of institutions (and really all traders), it is likely that non-custodial solutions will develop liquidity before custodial solutions can gain trust. So the question of “who will bridge Wall St and Crypto” is essentially this: which decentralized or partially decentralized solution can solve the liquidity problem?

In traditional markets, an ecosystem of players like market-makers, agency brokers, central banks and high frequency traders has developed over many years in order to increase liquidity (and profit from doing so). In this as in every other way, the crypto ecosystem is evolving very rapidly, and has generated a plethora of non-custodial liquidity solutions, such as Bancor, Kyber, AirSwap, Ethfinex, 0x, OmiseGo and Omega One. Each of these solutions is providing tools to improve crypto liquidity, and to varying degrees uses the power of decentralized technology and its own cryptocurrency token to do so.

These mechanisms can be broken into three main groups:

Decentralized exchange

Smart contract market maker or central banker

Trustless agency broker

Decentralized exchanges: AirSwap, 0x, Kyber, Ethfinex, OasisDEX, OmiseGo

Decentralized exchanges are by far the largest class of new entrants into the liquidity solution space. Rather than trying to create an automated buyer and seller of assets, these companies seek to find ways to bring existing buyers and sellers together that are safer, more efficient, or in some way better than existing methods.

While the individual mechanisms of each of these platforms are different, the general premise behind all of them is the same: that a decentralized method of connecting buyers and sellers will be sufficiently more valuable to those buyers and sellers than the traditional, custodial, off-chain methods.

Each platform makes different claims as to how that value will be created and extracted by their token. AirSwap, for instance, is a protocol that promises to eliminate transaction fees and to enable trustless swaps of assets, and its token is a claim on those services. By creating trustless and feeless trading (within a gated enclave that one needs to buy tokens to enter), AirSwap seeks to entice traders away from exchanges where they have trust risk (i.e. their funds are commingled and can be stolen or hacked in a way that funds on AirSwap cannot) and pay fees to trade. 0x is a low-level protocol with similar offchain matching, and allows decentralized exchanges (eg Paradex) to be built on top of it. Kyber uses onchain matching, which increases its decentralization, at the risk of performance issues and frontrunning. These and the other DEX solutions differ in the details, but all seek to create a trustless trading experience within a community, and thus build the liquidity necessary to compete with centralization.

The problem that each of these platforms face, of course, is the massive network effect of the centralized exchanges. Building a new exchange is somewhat akin to building a social media platform — the platform only becomes an attractive service after it has attracted enough users. Each of these platforms needs to create its own liquidity pool from scratch — or in some cases, create multiple disconnected liquidity pools in a decentralized way. Until they attract volume, trading in their liquidity pool will be a more expensive alternative, which makes it difficult to attract those clients. This is not an unsolvable problem — in fact it’s how every major exchange or e-trading platform has grown — but it requires patience, resources, and a lack of competition.

We expect that the decentralized exchanges will quickly attract small trades in markets that are generally liquid such as BTC-ETH. The relative lack of liquidity on these new platforms will be less of a barrier for generally more liquid markets. However, absorbing larger-size trading will be harder, because of the information leakage of these protocols (e.g. order signaling; for the on-chain solutions, frontrunning), and because of the fact that liquidity begets liquidity.

The best of the decentralized exchange protocols (SWAP, in our view) has a better shot of solving this multi-billion dollar liquidity problem than, say Bancor (section below). These decentralized exchanges are not subject to the same attacks and will provide a stable service in liquid markets. If and when they can acquire enough liquidity to make their solution cheap enough for all traders, there will likely be no turning back.

Smart contract market making: Bancor Protocol

The role of a market maker is to provide liquidity by sitting on the other side of the market from whomever has principal motivation to buy or sell, then find someone later to absorb the other side of the trade. This allows them to bridge buyers and sellers across time. By selling higher than they buy, market-makers are compensated for taking balance sheet risk (owning risky assets while looking for sellers) and incentivized to perform this service for the market.

The Bancor protocol implements this market-making function through a set of rules encoded in smart contracts on the Ethereum blockchain. The Bancor Protocol enables anyone with the ability to generate a smart contract, which operates by funding the balance sheet of said market maker with their own cryptocurrency tokens. In this way, Bancor operates as a mini central bank, buying and selling its currency against reserve currency using its balance sheet.

These market maker contracts are then released into the global computing surface that is Ethereum, until they are running on every Ethereum node and making bids and offers to all. This provides temporary liquidity aggregation, and helps to lower the cost of trading.

This type of solution is unlikely to change a a low liquidity market to a high liquidity market, but is extremely useful for creating some kind of a market for an asset that is otherwise completely illiquid. You can imagine it as allowing anyone to host a lemonade stand for their own token, which others can come buy at a certain price.

Because the number of potential small markets is extremely large, there’s significant potential value in the Bancor protocol. If we believe in a future where every residents’ association and store has its own cryptocurrency, and they desire seamless transitions between those cryptos, we can believe that such a protocol will hold massive value. However this is not the current reality, and Bancor is an interesting potential solution to a problem we don’t have yet, rather than a solution for the pressing problem of liquidity in the large crypto markets, where the simplicity of its market-making behavior (essentially pegging to a simple curve) has already shown it to unable to compete with smart traders and bots.

As a footnote, it’s worth considering the history of Bernard Lietaer, the intellectual godfather of and advisor to the Bancor project. We have huge respect for Dr Lietaer’s work, but students of monetary history will also recognize his role in the creation of the Euro, a fixed-peg mechanism that has been bleeding value under attack for years.

We will not go into a long digression on the Bancor protocol — for more on the Bancor protocol, that, read the savage takedown in Bancor Is Flawed — Hacking, Distributed and the very long point-by-point response in Response to “Bancor is Flawed” — The Bancor Protocol.

Trustless agency broker: Omega One

Omega One is taking another approach: filling the role an agency broker fills in traditional markets, but in a decentralized and non-custodial way. Like an agency broker, it takes orders from clients and then executes that order as cheaply as possible across any available liquidity sources, including its own internal pool, and centralized and decentralized exchanges. This is one of the most effective models for accessing liquidity in fragmented markets that are still developing liquidity-maximizing infrastructure. However the innovation in Omega One’s business model is that it does this in a non-custodial way by acting as a principal — using it’s own working capital to build up the client’s desired position on liquid centralized exchange and then settling it back to the client with a simultaneous atomic swap.

This allows Omega One to have the non-custodial benefit of atomic swaps, while accessing liquidity that is even greater than that which is available on any given centralized exchange. It is a solution specifically designed to capture the benefit of zero counterparty risk while maximizing liquidity instantaneously. An agency broker doesn’t have the to achieve a network effect to become liquid, because it immediately has access to the already existing liquidity from other venues.

Even before opening the doorway to new institutional money, the opportunity for reducing liquidity costs is huge. Currently, crypto traders pay $7bn in liquidity costs every year (Omega One estimate), so a platform that significantly cuts liquidity costs can generate many billions of dollars of value. Given the familiarity of the model to institutional players, the immediate availability of billions of dollars of daily liquidity across exchanges, and the fully non-custodial crypto trading, Omega One is well positioned to act as the bridge between Wall Street and crypto, moving more and more over time to trading over multiple liquid and trustless decentralized exchanges.

The Omega One Token Sale

The initial sale of Omega One tokens will be via an upcoming public token sale. There is currently a discounted presale with a minimum purchase of 30 ETH. To be considered for the presale, contact tokensale@omega.one.

Read Omega One’s White Paper

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