The DEX series - Part 1.
Discover the Decentralised Exchange:
Misconceptions, misunderstandings, solutions and the future
For some time now, or should I say, for the last ten years, the term „decentralisation“ has been pegged as the miracle cure for almost all of our problems. Do not get me wrong, there is nothing wrong with decentralisation, but only if it is used in the right place and at the right time. Decentralisation is not a solution to every problem. It is not even the solution to all the problems within the world of cryptocurrencies and blockchain technologies. Since this new super-concept is often misused or even misunderstood, articles like this one here need to be published to shed some light on what must be looked at. In truth, a whole series of articles is needed to cover the complicated topic of decentralised exchanges. This article is the first of five parts which will deal with the following topics.
1. History and evolution of Centralised Exchanges (CEX)
2. Definitions of the terms „decentralised & centralised“ and their connection to DEX & CEX
3. The Blockchain technology – a future way of trading assets
1. History and Evolution of Centralised Exchanges (CEX)
According to official figures, the history of stock trading, the father of all CEX, goes back to the 14th century. However, you can look back even further into the past and find the Romans already had the precursors of this very concept of trade. It is therefore an ancient business, based on the need to be able to trade goods that are not available on the spot into the hands of the actor. Due to digitalisation, if we look at the current situation of the trading market, we are almost always exposed to trading without the goods or the assets in our hands. History refers to the city of Bruges (Belgium) as the pioneers of modern trade in papers. What exactly did they do?
After the discovery of the West (today America), a race began. Using ships, who could trade new goods back to Europe in the safest and fastest way possible? To pay for the expensive expeditions and to own as many ships as possible, the shipowners were looking for investors to finance their boats and crews. In exchange for their invested money, the investors would get a share of the proceeds from the trading expeditions. These shipowners are considered the first corporations to issue paper stocks and pay dividends. With investors’ money, they were able to build larger fleets, get more profits and then demand more per share and repeat the whole thing. Their equity securities were first traded in important, old Europe cities such as Bruges, Antwerp, Lyon, and Toulouse; then later in London, Hamburg and Bremen. From the beginning, priority was given to the settlement and delivery. Now just imagine back in time 500 years ago. Traders were (and still are) interested in transporting goods, i.e. an asset, immediately and safely. Due to logistics, this was not always possible then, just as is often then case today. The equity securities traded on the CEX corresponded to the comparable value of the commodity, which is equivalent to the digital assets of today. Thus, a kind of mutual promise was made, in which the underlying value was secured by the shipowners as one of their obligations as custodians, and as insurers, they promised to deliver the asset on call. If we take the standard from the past and bring it into 2019, we quickly realise that we cannot meet in person to trade assets such as physical gold.
Out of a need to trade assets around the world, regardless of the distance, a new digital format as equivalent to the physical asset was born. Before we dive deeper into digital trading, let’s first look at two standard definitions of different exchanges the CEX and the DEX.
2. A Comparison Between Centralised and Decentralised Exchanges
The following is a stylistic comment that really stands out to me when I read this, although other people might not notice:
„A centralised market is a financial market structure that consists of having all orders routed to one central exchange with no other competing market. The quoted prices of the various securities listed on the exchange represent the only price that is available to investors seeking to buy or sell the specific asset. The New York Stock Exchange is considered a centralised market because orders are routed to the exchange and are then matched with an offsetting order. In more generic terms, a centralised market refers to a specialised financial market which is structured in such a way that all orders, whether they be buy or sell orders, are routed through a central exchange that has no other competing market for those particular financial instruments. Security prices that are available through and quoted by the exchange (or market) represent the only prices which are available to investors wishing to buy or sell the specific assets quoted on the exchange. One key aspect of centralised markets is that pricing is fully transparent and available for anyone to see. Potential investors are able to see all quotes and trades and consider how those trades move in formulating their strategies. Another key component of centralised markets is the existence of a clearinghouse, which sits between buyers and sellers and guarantees the integrity of the transactions as both buyers and sellers in effect, transact with the exchange and not with each other. The resulting benefit of reduced risk from not dealing with variable counterparties is also a key aspect of a centralised market.“
In comparison to that, we find the following definition of a decentralised exchange at cryptocompare.com:
„A decentralised exchange is an exchange market that does not rely on a third-party service to hold the customer’s funds. Instead, trades occur directly between users (peer to peer) through an automated process. This system can be achieved by creating proxy tokens (crypto assets that represent a certain fiat or cryptocurrency) or assets (that can represent shares in a company for example) or through a decentralised multi-signature escrow system, among other solutions that are currently being developed.
This system contrasts with the current centralised model in which users deposit their funds and the exchange issues an IOU that can be freely traded on the platform. When a user asks to withdraw his funds, these are converted back into the cryptocurrency they represent and sent to their owner.“
I have read many definitions of decentralised exchanges, and none of them can explain what happens in the background. My initial conclusion was that there must be an explanation within other versions. How wrong I was! I have not found a single article that explains what processes are essential for a decentralised exchange to work properly. For example, how is the price of an asset determined in less than a second using the blockchain? Instead, everything I found in my search boiled down to either what a user can do with the DEX, or superficially contrasted differences between different forms of the DEX. I was quite surprised to find that everyone else seemed satisfied with the same few repeated points when it came to contrasting centralisation vs. decentralisation. These repeated talking points resulted in a particular functional definition that has been accepted over time. It appears that to most, the only thing that matters are the two main advantages of a DEX. First, there is no third party and second, a DEX cannot be manipulated because it all happens on the blockchain, providing further protection. There is no doubt that centralised exchanges can be attacked, but is the decentralised exchange free of manipulation and fraud?
Everyone seems to believe that the egg-laying, wool-giving milk-sow has been found and that we are all free from now on as long as everything is decentralised. However, it’s not that easy. Questions about price discovery, order management, processing and position management are not being asked. Even the question of a decentralised exchange’s speed under high volume has not been explored. The purpose of this series is to get to the bottom of these essential questions. Let’s get started.
3. The Blockchain Technology – a future way of trading assets
Blockchain technology already offers new possibilities for asset management, leading to significant advantages over more traditional methods. The blockchain’s impenetrability, which is still misunderstood by most users, makes it possible to set an entirely new standard of security. However, we cannot leave the blockchain’s unanswered security questions to chance, as countless examples have already shown. 2018 was a record-breaking year for crypto exchanges when it comes to hacks. The most prominent of them (and in fact, biggest to date) was the Coincheck hack ($532.6 Million) in January.
The blockchain is leading us into the age of real transparency in trade, although this point is too often misunderstood and misinterpreted. However, what is already standard today is the speed advantage that exists with this technology, and it is certain that in the future, we will no longer have to consider the time it takes for a trade to complete. Perhaps the most significant change is the ability to trade any asset through the blockchain, but we are still in need of custodian parties for physical assets. It is also important to note that with the blockchain, previous constraints on trades, such as time and location dependency, have been lifted. To summarise: Trading will become faster, safer, more versatile through the intelligent application of blockchain technology, and it will be possible anywhere, anytime.
To be continued soon …