A Deep Dive into Kyber Network

It's important to first understand why Kyber, along with projects like 0x and AirSwap, are all building decentralized exchanges. From there, we'll take a deep look at how Kyber's exchange will function. After that, we'll see how Kyber's exchange will also function as a payment facilitator.

The Problem With Centralized Exchanges

In 2014, the world's first cryptocurrency exchange called Mt. Gox was hacked for $460 million worth of bitcoin. In 2016, hackers got away with $72 million worth of bitcoin from the Bitfinex exchange. In January of this year, the biggest hack to date occurred when $562 million worth of the cryptocurrency NEM was stolen from the Coincheck exchange. The Friday before Kyber went live, $170 million worth of a cryptocurrency called Nano was stolen from the BitGrail exchange.

These hacks happen because major exchanges hold massive amounts of cryptocurrencies on behalf of their users in a central location - thus, they are "centralized" exchanges. Cryptocurrencies use a combination of what are called public and private key encryption to function. These keys are long, randomly generated strings of characters that allow people to send and receive cryptocurrency. If someone is going to pay you, they direct the payment to your public key. If you want to pay someone else, you need your private key to authorize the transaction. If a hacker gets a hold of your private key, they can authorize transactions to cryptocurrency wallets that they control.

Exchanges hold millions of dollars of its users' funds in wallets on a central server. If a hacker can breach that server and steal the exchange's private keys, they can move everyone's funds out of the exchange and into a wallet controlled by the hacker.

The Decentralized Difference

Decentralized exchanges facilitate trades without ever taking custody of users' funds. They do this by using smart contracts executed on blockchain networks like Ethereum to enable trades peer-to-peer. If I want to trade 1` Ethereum for 70 OmiseGo tokens, the smart contract finds someone willing to part with 70 OmiseGo tokens in exchange for 1 Ethereum and makes the swap directly. The instant the Ether leaves my wallet I receive the OmiseGo; the funds are never in the custody of the exchange.

This exchange is decentralized because it consists of smart contracts that live on a blockchain network. The trades are executed by computers (miners) all over the world rather than on a central server - there is no single point of failure for a hacker to attack.

Of the decentralized exchanges being introduced (0x, Airswap and Kyber) Kyber is arguably the most decentralized since it runs completely on the Ethereum blockchain. While 0x and Airswap don't take custody of user funds, their smart contracts match buyers and sellers by consulting order books maintained on central servers. If these order books were compromised, it could be problematic for users. All trades on Kyber Network take place 100% on the Ethereum blockchain.

The Liquidity Problem

There are already several decentralized exchanges on the market. Despite the obvious security advantages, none currently handle significant volume. Decentralized exchanges like EtherDelta and IDex only handle about $4 million in trade volume per day. This is very low when compared to major centralized exchanges like Binance and Bithumb that handle billions every day. The major problem that stems from trading on an exchange with low volume is the lack of liquidity.

Liquidity measures the ease of buying or selling a particular asset at a stable price. Selling traditional stocks like shares of Apple Inc. on the Nasdaq is a highly liquid market because at any given time, there are plenty of people willing to purchase the stock from you at the going market rate. An example of a highly illiquid market would be selling refrigerators in exchange for toasters on Craigslist. Odds are at any given time, there aren't a lot of people on Craigslist looking to sell their toasters in exchange for refrigerators so you're going to have a tough time making that trade happen.

While this is a silly example, if you're trying to trade cryptocurrency on an exchange with low volume, it can feel like trading refrigerators for toasters on Craigslist. On a low volume exchange that suffers from low liquidity, finding someone to trade with takes a much longer time and the users often have to settle for undesirable prices.

Kyber's solution to the liquidity problem? Guarantee it through a system of reserves.

Kyber Reserves

The Kyber Reserve system is where Kyber Network differentiates itself from the rest of the decentralized exchanges on the market. You can think of a Kyber Reserve as a big pool of cryptocurrencies that are always available for trading. The equivalent in the traditional finance world is called a "market maker."

In foreign exchange markets, a market maker for the currency pair [Japanese Yen/US Dollar] is someone who has a lot of Yen and US dollars available for trade at all times. If an institution thinks that the USD is going to weaken and the Yen will strengthen, they can sell their USD to the market maker in exchange for Yen. The market maker profits through the "spread." If 1 USD = 100 Yen and the spread is $0.05, the market maker will profit 5 cents by accepting $1.05 in exchange for 100 Yen. There are usually multiple market makers who compete against one another for business by offering the best rates and the lowest spread.

Kyber Reserves will function in the same way but with cryptocurrency pairs. Anyone with a lot of OmiseGo and Ether could be an [OMG/ETH] market maker by committing their funds to a Kyber Reserve. The reserve manager will set the rates in which they're willing to trade OmiseGo for Ether and vice versa and will set their own spreads. These reserves will always be available to users of the Kyber Network for trading. Kyber's goal is to have multiple reserves for each pair that will compete for business by offering the best rates with the lowest spreads.

Who Will These Market Makers Be?

Foreign exchange market makers tend to be people with a lot of spare currencies lying around who want to put their idle assets to work - typically banks and financial institutions. Similarly, Kyber Network Reserve managers can be anyone with large stockpiles of cryptoccurrency. This could hypothetically be any of the following:

Whales - Whale is a term for an individual with huge stock piles of cryptocurrency. A whale could commit their funds to a Kyber Reserve and profit from the spread.

Whale is a term for an individual with huge stock piles of cryptocurrency. A whale could commit their funds to a Kyber Reserve and profit from the spread. Centralized Exchanges - Exchanges like Binance or Bittrex that collect millions in transaction fees in various cryptocurrencies could profit from managing Kyber Reserves.

Exchanges like Binance or Bittrex that collect millions in transaction fees in various cryptocurrencies could profit from managing Kyber Reserves. Fund Companies - Companies that invest in ICOs can put their assets to work by establishing Kyber Reserves.

Companies that invest in ICOs can put their assets to work by establishing Kyber Reserves. Project Founders - Founders of new cryptocurrencies all face the task of getting their token into circulation. A way for token issuers to do that could be to establish Kyber Reserves of their own coin to give the market access to it.

How Do Reserves Work?

To set up a Kyber Reserve, the reserve manager commits funds of any two cryptocurrencies to an account connected to a Kyber Network smart contract. Kyber has built software that allows the reserve manager to set their own spreads and rates. Kyber is not the custodian of these funds.

According to Loi, a small amount of reserves can support a large amount of trading. Let's say a reserve contributor commits 150 Ether and an equivalent amount of OmiseGo (11,000 OMG at current rates). If a user wants to buy 1 Eth for 70 OMG tokens, the reserve receives 70 OMG tokens and loses 1 ETH. If a user wants to buy 70 OMG for 1 Eth, the reserve will lose 70 OMG and gain 1 ETH. Under market conditions where Kyber users are buying and selling similar levels of Ether and OmiseGo, the reserve will maintain its initial level of both ETH and OMG and can maintain a trading volume that exceeds its total contribution (i.e. 150 Eth /11,000 OMG reserve can support 1,500 ETH / 110,000 OMG trade volumes).

If Kyber users start heavily selling Ether to buy OmiseGo, this would cause the reserve's OMG levels to deplete and its Ether levels to accumulate. This is where Kyber's rebalancing feature kicks in. The Kyber Reserve software has a function that uses a combination of trading bots and smart contracts connected to major exchanges like Binance, Bittrex and Huobi. In the scenario described above, Kyber's automated software would trade the excess Ether for OMG with the centralized exchange offering the best rate to bring the reserve back to its original levels. This lets reserve managers profit from their assets while still maintaining their original investment.

Kyber Network Crystals - KNC

Kyber Network's native asset is the Kyber Network Crystal (KNC) which is an essential part of the reserve system. To earn the right to profit from spreads on the Kyber Network, Kyber Reserve managers are required to purchase KNC. When a reserve completes a trade and profits from the spread, a percentage of that profit is paid to the Kyber Network in KNC.

Kyber Network uses the KNC to pay for its operating costs and to pay its supporters. For example, a wallet that integrates with Kyber Network will get a percentage of the KNC payment as a referral fee for sending a user to the network. Once supporters and operating costs are paid, the remaining KNC is "burned", which means that its taken out of circulation. As more reserves are opened and the total supply of KNC is gradually lowered due to the token burning, demand for KNC tokens should increase over time.

If you are speculating on KNC, you are rooting for a robust network of Kyber Reserves because demand for KNC tokens is proportional to the amount of reserves in operation.

Trading on Kyber Network

While Kyber Network will allow whales, exchanges and funds to profit from their idle assets, the exchange was built with convenience of the end user in mind. Users will be able to easily connect to the Kyber Network without setting up an account through the following ways:

Hardware Wallets - Users can go to the Kyber Network website and directly connect their Trezor or Ledger Nano hardware wallets Software Wallets - Users of software wallets that integrate with Kyber Network will be able to connect directly from their wallet. So far, Kyber's list of wallet partners includes ImToken, Coin Manager and Trust Wallet. Once Kyber is available to the public, users of these wallets will see the Kyber option in the wallet's user interface.

Once connected to the Kyber Network via hardware or software wallet, trading is very simple. The user will see all of the trading pairs offered by Kyber Network. Any pair that a user sees will have at least 2 supporting reserves and will be available for instant trading.