Heralded as a way to put true custody back into the hands of traders, decentralized exchanges have moved out of R&D phase and are enrolling early adopters. But before users can start rejoicing, there’s a serious chicken-and-egg problem, one that entrepreneurs believe is preventing the model from challenging the Coinbases and Krakens of the world.
In short, you need liquidity to get adoption, yet in order to get adoption, liquidity must be good, a fact acknowledged by even those who see the potential in more high-tech trading offerings.
But more broadly, it’s worth looking at how centralized exchanges solve this problem. Oftentimes, they make deals with market makers to incentivize them to create liquidity. These incentives usually come in the form of a rebate or reward that’s exchanged for the guarantee a certain amount of what traders call “order book depth” is maintained at all times.
Some centralized exchanges will even employ temporary strategies to solve the problem, such as market making themselves with their own capital, and will basically replicate order books from other more liquid exchanges (plus a spread) to try to attract traders.
There are some practical issues: decentralized exchanges are limited to trade in cryptos only. That means people can’t actually use regular US dollars to buy a token. They first have to go to a regulated exchange to put in US dollars (or other government-backed currencies) to buy bitcoin or ether.
Then, with bitcoin or ether, they can go to a decentralized exchange to buy the more tokens. As such, it’s perhaps no surprise that to those familiar with more user-friendly Wall Street solutions, this can all seem a bit much.
As Daniel Cawrey, CEO, Pactum Capital explains:
“Most investors/traders are already intimidated by bitcoin. So, to have them jump through hoops to trade on a decentralized exchange to trade a token with a tiny market cap causes a lot of people to give up.”
Cawrey characterizes it as a question of cost and benefit. Essentially, most tokens don’t do much in the way of volume, which makes the set-up hurdles even more pronounced.
That said, there have been early successes.
For example, AirSwap, the decentralised marketplace for ethereum tokens that launched last week, handled over $1 million worth of transactions on its first day of trading.
A different take
Still, those working to bring the business model to life see it differently.
AirSwap, co-founded by former Virtu Financial trader Michael Oved, goes so far as to use a bulletin board-style system that emulates the way traditional foreign exchange traders interact directly with each other, peer to peer.
The platform replaces the traditional order book with a kind of search engine called an “indexer,” whereby traders can announce their intent to trade, making them discoverable by their peers using smart contracts. It currently trades some 25 tokens and that number is growing.
In this way, AirSwap co-founder Don Mosites believes this selection is enough to overcome the issues Cawrey discussed, by offering a selection of markets that may be small today, but have been growing in volumes of late.
Mosites said: “There are people all over the world looking to make trades, often in large amounts, but may not have the tools.”
“The first-day volume was a testament to the global community we’ve built, our ‘peer discovery’ system and the smart contract used by peers to make trades. There is a ton of demand for a simple and secure OTC system like this,” he continued…