Hong Kong-based Spark has just launched a decentralized exchange, or DEX, aimed at cash-based businesses like money-transfer operators.

For Spark founder Maxine Ryan and other people in the crypto-currency world, DEX is the future, and more projects in Asia have recently launched or on the drawing board.

“Decentralized is the right way to go,” said Ryan. “We’ve been reliant on central exchanges, beholden to their fees and their structures.”

Amanda Liu, general manager at OAX Foundation, a Hong Kong non-profit that raised the US dollar equivalent of $19 million from an initial coin offering last summer to build a DEX, said, “Decentralized is the trend; central exchanges are too vulnerable.”

But for others, DEX represents a distraction from building the infrastructure necessary for attracting liquidity to crypto markets. No DEX has yet generated the kind of trading volumes needed to establish the sector. And it’s only a matter of time before DEX face regulatory scrutiny.

There’s DEX and there’s DEX

Decentralized exchanges are blockchain businesses with no physical jurisdiction that facilitate peer-to-peer trades of a token or crypto-currency. In their purest form, they are a set of smart contracts that match buyers and sellers anonymously. More hybrid versions are meant to act like centralized crypto exchanges but without handling custody.

Amanda Liu, OAX Foundation

Some like Spark’s exist to serve a customer base with a more efficient service, in this case remittance companies and MTOs that want to transmit payments without a bank (see case studies, below). Other DEX cater more directly to crypto traders by linking liquidity available on multiple centralized venues, or to exchanges looking to remove themselves as a target of hackers (by diffusing the custody of assets back to the account holders).

Many centralized exchanges have announced DEX projects, extending their reach into a pure P2P capacity, including ANX International (whose founders also set up OAX Foundation) in Hong Kong, exchanges such as Binance and Huobi that originated in China but have since moved to Malta or other jurisdictions, Thailand’s OmiseGo and Taiwan’s StarBit, and U.S. players like Kraken and Coinbase.

There is also a new breed of standalone DEX projects, such as AirSwap, IDEX, Kyber Network and Waves Platform. Many of these are built on the Ethereum blockchain.

Industry officials say there are already as many as 50 DEXs in operation or going live worldwide, with more to come.

Challenges

Even DEX’s proponents acknowledge these P2P venues have their challenges. “Decentralized exchanges aren’t popular,” said Antoine Cote, co-founder and CEO of Enuma Technologies, the vendor building OAX Foundation’s exchange.

They seek to get end users to trade peer-to-peer without providing other services, and because these are meant to be anonymous, there’s no know-your-customer (KYC) function available – that has to take place somewhere else, on a centralized exchange or with an over-the-counter broker.

DEX is secure: P2P is just a private exchange between two parties, and it can’t be hacked. But building a P2P capacity does nothing to address the needs for custody elsewhere in the chain.

Antoine Cote, Enuma

DEX are meant to provide liquidity by enabling people trading two coins to transact literally anything that’s tokenized, so in theory this should connect liquidity among centralized exchanges. Companies like AirSwap have developed Google-like search capacities for users to find bids or offers.

So far, however, several industry execs tell DigFin that liquidity on existing DEX is poor and the user-interfaces terrible. P2P is likely to play a useful niche, like OTC brokers do in classic finance, but they have yet to show they can aggregate liquidity.

Moreover, P2P has appeal to a narrow set of traders: individuals that are familiar with the industry infrastructure, but mainstream retail investors are probably not going to use these.

And more: because of the lack of custody as well as the lack of any licensing for private networks to operate, institutional investors – the holy grail of crypto infrastructure projects – are unlikely to ever use these.

“It’s hard to onboard fiat money if there’s no licensing,” said John Patrick Mullin, managing director at Trade.io in Hong Kong, which launched a centralized exchange this year. “The ICO boom is over, so the industry needs liquidity – now. To expand crypto [volumes] we need regulated exchanges.”

If DEX remain a niche play, they will also struggle to compete for talent against centralized exchanges that enjoy high volumes and high revenues, such as Binance or derivatives platform BitMEX, says a fintech founder working on a custody solution.

It’s also unclear how long DEX can go without entering some kind of regulatory oversight if they don’t have an answer to customer due diligence. The Financial Action Task Force, a global body overseeing anti-money laundering efforts, is looking to apply its principles for banks to crypto, including DEX, and other regulators will follow.

The promise

Against these concerns are hopes that DEX can improve liquidity and security.

Enuma’s Cote says DEX, by allowing users to chop orders as they need, can help investors transact large blocks, as liquidity is problematic for many coins on even large centralized exchanges.

Others such as Spark’s Ryan say the adoption of stable coins – tokens pegged to a fiat currency or a commodity – will facilitate more institutional or corporate money into crypto. Waves Platform, for example, handles dollars and euros.

Others are working on improving the interface to make DEX more retail friendly. Kyber Network, for example, has removed the order book function from the user’s app, and instead customers just see the best bid or offer for a given token from market makers using its DEX.

But security is the most important driver for DEX.

Michael Oved, co-founder at AirSwap, at a conference earlier this year, noted that his former employer, Virtu, a broker, cleared everything through AIG. This gave it access to financial markets – until AIG went bankrupt in the 2008 financial crisis. The lesson: centralized entities of any kind present a systemic risk.

Case study: SparkDEX

Unlike most DEX, Spark’s is not intended to attract crypto speculators. It was launched to support Spark’s business of providing bitcoin-based payments for companies that are being shut out of the banking system. “We allow any business to be bankless,” said founder Maxine Ryan. “We are replacing traditional financial infrastructure.”

Spark was the first money-transfer business to use bitcoin, beginning in 2014, she says. With its DEX, Spark is transitioning from the bitcoin blockchain to its own, so it can evolve into a platform for any customer to use to transfer among any fiat currency pair.

She sees growing demand from money-transfer operators and other cash-based businesses that are being “de-risked”, i.e. fired as customers by banks. These players deposit cash physically at Spark’s vault (in Hong Kong and in three other locations), and in return get Spark tokens denominated in Hong Kong dollars. Until now, Spark would let them transact against other currencies by trading in and out of bitcoin, but this left it exposed to the mercies of other crypto exchanges.

Now with its own exchange, built on a third-party blockchain called BitShares, users can generate tokens to trade or distribute to Spark’s other cash-out centers. These come in two varieties.

One is a user-issued asset, which allows users to create their own coin on BitShares – which could represent any kind of asset, unit of value or ownership. The other is a market-pegged asset, a “stable coin” whose value is linked to an underlying fiat currency’s; the value is meant to be secured by the issuer putting in a large collateral amount of the underlying. (See our article on collateral-backed stable coins and their challenges.)

The medium-term goal for Spark is to have up to 180 currency-backed tokens on its exchange, each liquid enough to support a market for MTOs, remittance companies and other cash-based businesses. First, though, the company is launching its DEX just with bitcoin and ether, because the exchange needs to attract enough liquidity to convince customers to launch their own stable coins there.

Case study: OAX and Enuma

OAX Foundation, a non-profit entity set up by the principals behind ANX International (affiliated with the company OSL), launched a prototype in June and aims to launch a formal offering in 2019. Enuma Technologies is building the platform (on the Ethereum blockchain) and the governance to go with it. It intends to create a secure and stable DEX that depends on some centralized aspects, including for KYC. The foundation’s ICO last summer sold OAX tokens that users will use to transact in and out of other tokens (such as bitcoin) that trade there. “Trading is peer to peer,” said Antoine Cote, Enuma’s CEO, “but client onboarding is centralized.”

So why bother? To remove the centralized exchange as a point of vulnerability: each user keeps their own wallet, on a hardware device or in a mobile app. Security for the customer is just one business driver: another is the desire by ANX to not be liable for custody issues. Crypto exchanges could, in theory, charge users for the service of safekeeping assets, but none do, and players fear losing business if they charged. So better, perhaps, to push responsibility back to the users.

A DEX is also meant to provide liquidity, by enabling traders to trade assets they can’t readily find on a given exchange. And, says Cote, Enuma is working to allow OAX trading to occur much faster, as close to real time as possible. This requires choices: should trades settle on or offchain? Should there be a centralized order book? Do trades go to the chain as soon as they’re agreed, or in batches? Should a DEX remain only for crypto-currencies, or can it accommodate fiat?

Questions also remain on issues such as the business model – should OAX tokens charge a transaction fee? Should there be a proof-of-stake model in which some members get a vote in how the DEX is operated? How does OAX incentivize users to pitch in with the exchange’s governance?

“It’s like developing a housing project,” Cote said. “Once the platform is built, it’s up to the members to run it.”