This article is from:Chain News ChainNews（ID：chainnewscomThis article is from:
Chain News ChainNews
), by Mansi Prakash, reposted with permission.
The words centralized and decentralized are very popular nowadays, but in fact, exchanges are not only in these two forms. There are plenty of variations from absolute centralization to absolute decentralization. To truly understand whether an exchange is centralized or decentralized, all variations must be considered.
Currently, more than 99% of cryptocurrency trading volume is done through centralized exchanges.
What is a centralized exchange
If you have ever purchased cryptocurrency through a website, such as Coinbase, Gemini, Poloniex, Kraken, you have used a centralized exchange. This directly means that you are transacting through traditional payment methods, such as credit cards or wire transfers.
A centralized exchange is a platform or application that allows traders to buy and sell cryptocurrencies using fiat or other cryptocurrencies. It is a marketplace for token transactions. Users deposit money directly into the exchange, and the exchange acts as a wallet to keep the funds until the order is generated. Exchanges keep their systems off-chain, which means these transactions are not recorded by the blockchain. Once the order is generated, the exchange will match the buying and selling orders in real time.
In this case, the key point is that when you deposit funds or trade on such an exchange, you do not hold the private keys of the cryptocurrency. Currently, 73% of centralized exchanges help users keep funds, while another 23% let users control their own passwords. Like a bank, you trust these centralized exchanges to safely store and manage your finances.
Although there are certain security guarantees for storing your encrypted assets on a centralized exchange, it also has fundamental risks:
Fraud can lead to loss of user funds: centralized exchanges are legally responsible for user funds, but are often suspected of theft.
Advance transactions are operated by the managers or related parties of the exchange.
Market liquidity concentrated on a few exchanges: An exchange like Coinbase with only a few cryptocurrencies can take advantage of its large user base. Whenever new coins are added, these tokens will gain popularity with the public and may see token price increases.
What is a decentralized exchange
In a perfect decentralized exchange, users would have control over their funds. The goal of a decentralized exchange is to create a peer-to-peer marketplace directly on the blockchain. Funds are not sent to an exchange or wallet owned by a single platform or institution: instead, orders and transactions happen on the blockchain. As a result, there are no intermediary fees, assets are immune to hacking attacks, and users truly have control of assets.
But it must be pointed out that the vast majority of existing decentralized exchanges are semi-decentralized. In most cases, the centralized server keeps the orders off-chain, but does not control the private keys. But orders are fulfilled on-chain, and they go through the entire blockchain process. There are four different decentralized exchanges: exchanges, P2P transactions, dark pools (ark pools, originally referring to off-site anonymous matching platforms established for large transactions), and open protocols for decentralized exchanges.
1. Exchange
Usually a decentralized exchange can decide whether to put its order book on-chain or not. But the key is whether to complete the order on the chain. In some cases, an order is generated, there may be a relayer or the order itself triggers the related matching process. Users gain control over their funds and data; however, there is a clear trade-off here.
On-chain transactions: users control their own funds and data, but on-chain transactions are a tedious process.
Order Book: An on-chain order book means that miners have implicit knowledge of an order that has not yet been generated, creating opportunities for front-running transactions. On-chain order books do not incur the same cost of forking on the blockchain as executing code, making either changing or revoking orders can quickly become expensive.
Advance transactions operated by miners or relayers: Because the order is completed on the chain, the miner can act as the counterparty to choose to execute the canceled order; even, the miner can also obtain the handling fee from the failed order cancellation.
Automatic matching: In the case of off-chain matching of orders, the exchange may not automatically match, which allows the exchange to delay or pre-trade the order.
Liquidity: Due to lack of users, liquidity will be missing, which will lead to extreme volatility in price, especially if there are large orders generated.
Cross-chain transactions: Most decentralized exchanges currently support Ethereum-based transactions or ERC-20 tokens, but lack the ability to support cross-chain transaction orders. For example, transactions through Bitcoin, Litecoin, etc. networks or operate. The reason for this is that it is difficult for two chains and their orders to communicate with each other since they have not met in any other context.
2. P2P transaction
Peer-to-peer transactions do not require an order book, as users connect directly to each other through nodes to trade. There are no middlemen or order books to facilitate the matching process. Price negotiation can be on-chain or off-chain, but the key point is that the transaction must still be completed on-chain.
On-chain transactions and real-time nodes: In the P2P system, since the matching process is driven by the user himself, the user must be online before the order is completed. Users cannot simply initiate an order and wait for a relayer or exchange to fulfill it.
Lack of order book: The lack of an order book will reduce the chances of miners making front-running transactions, because miners will not see the order before it is published on the chain.
Front-running and automatic matching: Because there is no order book, the risk of front-running orders is minimized. P2P exchanges use protocols that simplify the process of automatically matching generators and receivers.
Liquidity: Since there are not many users, there is a lack of liquidity, which leads to more turmoil in the market.
Cross-chain transactions: P2P exchanges can use the atomic swaps programming language to enable cross-chain transactions. Atomic Swaps uses a hash time-locked contract to establish a payment channel between two blockchains. It needs to be clearly pointed out that this method is not a panacea solution, not every blockchain supports it, and sometimes it is necessary to set up the Lightning Network.
3. Dark pool exchanges
Dark pool exchanges typically run hidden order books. The order matching process does not reveal the identity of the trader, or the transaction itself is also carried out in a covert manner, and no information will be leaked unless the transaction is completed. This is beneficial for trustless large block orders. In addition, because of the existence of a hidden order book, traders do not need to maintain a connection to the network when orders are matched. Once an order is generated, nodes will run matching calculations until a match is found or the order is voided.
On-chain transactions: Users control funds and data themselves, but on-chain transactions are a tedious process.
Hidden Order Book: Without exposing trader information, the hidden order book will match orders, allowing for large block orders without causing market volatility.
Front-running: As the order book is hidden, the risk of front-running is minimized. However, once information leaks, exchanges and traders will be vulnerable to front-running transactions and node attacks.
Liquidity: These exchanges lack users, resulting in a lack of liquidity to complete transactions.
Cross-chain transactions: Atomic swaps and Lightning Network can be used to allow cross-chain transactions.
4. Open protocols for decentralized exchanges
An open protocol is an infrastructure or platform that allows anyone to build their own services on top of it to run decentralized applications. A protocol is a conduit for carrying decentralized applications.
Ecology of decentralized exchanges
Below is an overview of current projects and startups by category. This is by no means an exhaustive list. Please note that the mark * indicates that it supports cross-chain or legal currency, and the rest are concentrated in ERC-20 tokens.
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Centralized exchanges that use off-chain order books and off-chain fulfillment mechanisms include Coinbase, Gemini, Kraken, Binance, and others.
Decentralized exchanges that use on-chain fulfillment and on-chain/off-chain order books include IDEX, NEX, Barterdex, Legolas, and various 0x relayers such as RadarRelay.
P2P exchange
P2P exchanges include centralized examples like ShapeShift, as well as more decentralized options that allow transactions to be completed on-chain, such as Airswap, Altcoin.io, Bisq, Etherdelta, KyberNetwork, and Bancor.
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Open protocols and dark pools
The open protocol allows developers to use its basic framework to create their own decentralized exchanges and expand liquidity. Examples include 0x, Loopring, OpenRelay, Lendroid, Swap, Heridus, Blocknet, and Bitshares.
Examples of dark pools that offer hidden order books include Republic Protocol and OmegaOne.
A few summaries
In view of the current status of players in the exchange ecosystem, several key elements need to be clarified when designing an exchange, and these issues need to be considered:
Purpose: Who are you designing for and what is the key purpose of the exchange.
Order books and matching orders: When there is an order book, decide whether to place it on-chain or off-chain, and ensure that front-running issues are resolved. In a P2P system, the key is to decide how orders are traded without having to be constantly online.
Delay and front-running transactions: Design a process to ensure that orders can be canceled immediately, and solve the problem of miners leading transactions due to potential time differences between off-chain order books and on-chain transaction writes.
Liquidity: Think more about ways to improve liquidity, and design an easy-to-use exchange with a friendly user experience that can be understood by various individuals.
