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Why Liquidity Networks Are The Future Of Decentralized Exchanges

The recent furor around Canadian cryptocurrency exchange QuadrigaCX has proven that, even now in 2019, dealing with centralized cryptocurrency exchanges can still be a risky business. The founder of Quadriga, Gerald Cotten, was apparently the only person holding the private keys to around $135m of cryptocurrency belonging to the exchange’s customers.
As news of his death emerged, customers realized they may never get their money back. The situation highlights the necessity of ensuring adequate security measures around private keys.
Decentralized exchanges (DEXs) have been touted as a solution to the security issues faced by centralized exchanges such as Quadriga. A DEX provides customers with a non-custodial means of exchange, so each user is responsible for their own private key to access their funds. The exchange acts only as an order-matching engine, with smart contracts enabling trades between peers placing buy and sell orders directly on-chain.
One of the most popular DEXs is IDEX, which is developed on the Ethereum blockchain. Another example is the Waves DEX, based on the Waves platform. The latter also offers users the opportunity to exchange fiat currency.
Limitations of Decentralized Exchanges
Using a DEX solves the security risk of trusting funds to a centralized exchange, provided that users keep their own private keys safe. However, using a DEX also comes with some drawbacks.
Firstly, due to a lack of interoperability between blockchains, many DEXs only offer trades in tokens based on a single blockchain. For example, users of IDEX can trade in ETH or tokens developed on Ethereum. If someone wishes to exchange Ethereum-based tokens for EOS-based tokens, they will need to use a centralized exchange as a medium. Ironically, this kind of DEX actually makes centralized exchanges even more essential to the crypto trading ecosystem.
Furthermore, liquidity with DEXs is a challenge given their current user base is far smaller than the dominant centralized exchanges. The Waves DEX offers more trading pairs than many other DEXs, with the opportunity to exchange BTC and LTC alongside fiat. However, 24-hour trading volume can be over 300 times higher on the top centralized exchanges like Bithumb and OKEx compared to the Waves DEX.
These vastly lower volumes result in a lower level of liquidity for a DEX compared to a centralized exchange. Cryptocurrency markets are notoriously volatile, so traders risk losing out to slippage if there’s a delay in order matching, which can easily happen if an order fails to find a quick match in an exchange with low liquidity. Should the price fall during this delay, the value of the trade also decreases.
Liquidity issues don’t just affect users either. Many of the more obscure alt coins also suffer from low liquidity as they have smaller numbers of traders and investors. Therefore, there’s little to no value for these token developers in listing their tokens on a DEX.
Liquidity Networks
A liquidity network introduces a “third” smart contract-enabled token as a medium of exchange to facilitate trades, thereby eliminating the need for an order matching process. For example, a trader wishes to exchange Token A for Token B. In the background, invisible to the user, Token A is exchanged for the liquidity network token, which is then exchanged for Token B.
This means that unlike a centralized or decentralized exchange which needs to set up specific trading pairs, every token on a liquidity network becomes tradable for every other token, creating a powerful network effect.
Moreover, anyone can add a token to a liquidity network simply by staking the network token in a smart contract which they own and manage. This creates a pool of reserves which provides instant funding for the trade.
Comparing Features of Liquidity Networks
Bancor was the first to launch a liquidity network in 2017, with Uniswap following it only recently. While both networks adhere to the above principles, each has its own characteristics offering different benefits and drawbacks.
Uniswap is developed on the Ethereum blockchain and uses ETH as its network token. Users can exchange between ETH and/or any pair of ERC-20 token that has liquidity on the Uniswap network.
While Ethereum has been the development platform of choice during the ICO boom of 2017 and early 2018, many other development platforms have now launched a main net. Some notable examples are EOS, Tron, Qtum and more recently, Zilliqa.
More platforms mean there’s an imperative for interoperability between different blockchains. This is why Bancor originally built its network on BNT, instead of ETH, allowing for conversions to occur across any blockchain.
So far, the Bancor cross-chain protocol has enabled conversions between tokens developed on Ethereum and EOS, enabling over 9,500 trading pairs across 140+ tokens. Comparatively, Binance is one of the biggest centralized exchanges, with 153 tokens but only 443 trading pairs.
Uniswap provides all users with the opportunity to contribute liquidity, which has enabled it to grow quickly. While Bancor originally offered the same ability when it launched, currently only token issuers can contribute liquidity on the Bancor network.
Concluding Thoughts
Decentralized exchanges are still in their earliest iterations. However, they need significant further developments in interoperability and user adoption if they are to compete with the might of centralized exchanges like Binance and Coinbase.
On the other hand, liquidity networks such as Bancor combine the liquidity benefits of a centralized exchange together with the non-custodial benefits of a DEX. Therefore, unless DEXs make significant strides in the immediate future, it’s likely that liquidity networks will take their place as the next generation of cryptocurrency exchanges.