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CryptoChat #62

The Future of 'Decentralized Exchange'

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This week Alex Wearn, CEO of IDEX, published an article explaining his decision to block access to New York IP addresses. Wearn also announced that his exchange will soon begin instituting KYC procedures for all users in order to comply with money laundering and sanctions laws.

For those unfamiliar, IDEX is currently the most popular ‘decentralized exchange’ (DEX) on the market: at its peak in May 2018, the exchange saw over 21,000 ETH in 24hr volume. For context, Paradex, the DEX relayer recently acquired by Coinbase, peaked at just over 7,000 ETH in 24hr volume back in September.

This ‘pragmatic’ approach to the regulatory landscape will likely surprise, and possibly anger, ‘decentralization maximalists’, who might interpret the move as a direct repudiation of the very ideals that blockchains strive to maintain – namely the ability to interact with applications in a ‘censorship resistant’ and ‘permissionless’ capacity.

Indeed, ShapeShift, the coin conversion service, received similar backlash in September when CEO Erik Voorhees announced the introduction of KYC as a “proactive step...to de-risk the company amid uncertain and changing global regulations.”

In reality, this surprise and anger is simply born out of confusion as to the current state of the DEX landscape: indeed, the vast majority of DEX implementations have never truly afforded ‘censorship resistant’ trading.

Rather, as AirSwap co-founder Michael Oved recently noted, most DEX operators continue host, match, and execute orders on their own private servers.

To be clear, the decision to move these operations ‘off-chain’ is largely for practical purposes: if order books and order matching took place ‘on-chain’, they would be subject to scaling constraints and, more importantly, susceptible to front-running by enterprising miners.

Nevertheless, these design decisions leave users in a semi-precarious state where they still need to ‘trust’ DEX operators to act honestly: as such, price discovery may not always occur in a fair and transparent way.

The actions of IDEX and ShapeShift should not be dismissed as outliers. Rather, this is the start of a growing trend within the DEX ecosystem, with operators now waking up to the fact that refusal to implement these procedures will likely be interpreted as violation of the Patriot Act. It will not be too long before KYC-less trading is relegated to a relic of the past.

Of course, this has quite serious implications for the DEX market business model, where the ability to trade in a KYC-less capacity was often the primary allure.

So if DEXs must soon forfeit this favourite feature, on what grounds can they continue to distinguish themselves from their centralized counterparts like Coinbase Pro and Gemini?

The first competitive advantage is the ability to list crypto assets at the early stages of their life cycles. DEXs have long taken a more lax approach to the listing process, supporting tokens immediately after their launch and providing a home to controversial and/or subversive projects like SpankChain and MakerDAO.

And yet, as with the KYC issue, it remains questionable as to whether DEXs will continue to be able to offer these services in the coming weeks, months, and years. In all likelihood, DEX operators will have to a) contend with SEC guidelines regarding the ‘unregistered security’-like nature of many of these assets or risk facing penalties and prosecution and b) compete with the liquidity of centralized exchanges that slowly start supporting the more kosher offerings, like Basic Attention Token and ZRX, both of which were recently added to the Coinbase Pro roster.

The second competitive advantage, and in my opinion the most significant feature of the DEX ecosystem, is the non-custodial nature of these trading venues. Unlike Gemini, Coinbase Pro, and the litany of other centralized exchanges on the market, DEXs permit users to trade directly from their wallets, thereby removing any risk associated with storing capital with third parties.

Whether deliberate, a product of incompetence, or a hybrid of the two, at this point in the industry’s life cycle it should be clear that trusting exchange operators with your assets can lead to disastrous outcomes: the collapse of Mt. Gox in February 2014 was just the first in a long history of operator malfeasance. Indeed, just this past week, the founders of MapleExchange disappeared with $6m of user funds. It remains unclear as to whether this was the result of an ‘exit scam’ or a breach of the exchange’s systems. In reality, it doesn’t really matter as user funds are still missing.

Providing infrastructure that ensures users that their funds will not disappear overnight is a fantastic step in the right direction.

And yet even this structural competitive advantage is at risk of being co-opted by centralized exchanges through emerging Layer 2 technologies like Plasma, which permit the likes of Coinbase and Gemini to maintain the throughput advantages associated with centralized operations while simultaneously affording customers the ability to custody assets themselves.

This is not to say that centralized exchanges will only offer non-custodial support: indeed, it seems likely that, despite the risks inherent with relying on third party custody, a significant proportion of customers would actually prefer to leave custody up to exchanges.

Rather, centralized exchanges now have the added advantage of being able to offer multiple custody solutions, thereby eliminating the key unique-selling-point of the existing DEX landscape.

To the detriment of the DEX landscape, the threat of regulation and the continued development of non-custodial infrastructure are equalizing forces, closing the chasm between the offerings of centralized and ‘decentralized’ trading venues.

As a result, competitive advantage between these two sectors will come down to features like: trading fees, user experience, insurance, customer support, and, perhaps most importantly, liquidity. With significant first mover advantages in optimizing for these properties, I must assume that existing centralized exchanges will likely out-compete their DEX competitors.

This trend towards centralization raises the question as to whether the endeavours of ‘decentralized finance’ protocols like 0x and Dharma were ‘worth it’ in the first place. Despite best efforts to move away from reliance on centralized incumbents, it seems as if we are slowly returning back to the status quo.

I think how you answer this ultimately depends on how you approach this space as a whole – is it a revolution or a renovation? Is it about disruption or optimization? And what about disintermediation?

My thoughts on this topic have evolved over time and are likely to evolve further: indeed, the complex and constantly changing nature of the crypto asset environment requires a healthy dosage of flexibility in the way that we address these issues.

At present, I take the approach that revolution for revolution’s sake is not ideal or practical. I think we must contend with the existing state of affairs, acknowledging that the hegemonies of today’s societies are unlikely to disappear any time soon. The rallying cry of disintermediation can be attractive, but, as Tony Sheng has articulated well in the past, “rent-seeking only occurs when wealth is redistributed yet no new value is created,” and so we must remain vigilant as to the targets we pick.

In the near-to-medium term, what we can, and must, do is continue to push for efficiencies in areas that have underperformed and underserved due to technological constraints. A relevant and timely example includes blockchain-based ‘fiat-coins’, like GeminiUSD, which, although subject to censorship and requisition, unlock near-instantaneous settlement and low-cost fees for cross-border macro transactions and permit traders to deposit and withdraw funds outside of traditional banking hours.

In the context of exchanges, we must pressure centralized incumbents to adopt non-custodial features. Considering that custody is the predominant source of woes in the exchange landscape, any marginal improvement there should be well received by users. Indeed, the adoption of non-custodial trading may have second-order effects in the form of fee reduction, as exchanges are no longer burdened with investing resources into ensuring that customer assets remain safe and secure.

It should be noted that, despite the relatively bleak outlook outlined above, there is still room for ‘truly’ decentralized exchanges to prosper, although to do so they must be structured in a way that protects them from regulatory oversight.

This means adopting the types of architectures leveraged by the DutchX protocol and UniSwap, the former of which is governed by a Decentralized Autonomous Organization, the latter shirking all dependence on central operators.

These design decisions come with tradeoffs – namely the ability for miners to front-run users, susceptibility to plutocratic decision making, and lack of liquidity compared to centralized venues — but their emphasis on ‘decentralization’ also allows for permissionless trading and the support of grey area, or ‘alegal’, assets.

In closing, I encourage everyone to use IDEX’s transitionary period as an opportunity to reflect upon the ambitions of this movement and the myriad obstacles that we must overcome before they can be fully realized. ‘Decentralization’ is not a goal in itself but rather a means to a fairer, more transparent end, and thus we must ultimately accept, and welcome, the notion that the subjects of this ‘end’ may take the form of the same institutions that we sought to overthrow in the first place.

I look forward to continued discussion around this topic. Please direct comments and questions to matteo@cryptochat.us.

I own some ZRX tokens. This is not investment advice.

Many thanks to Camson McInnes, Chris Ware, and Keegan Toci for their feedback.

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Please note, I am not a professional investor and this newsletter should by no means be considered investment advice. Cryptocurrencies are an emerging and highly speculative asset class. I am not liable for any gains/losses that you may incur.

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