Evolution of Decentralized Exchanges

The Evolution of Decentralized Exchanges

Background

The world was introduced to the revolutionary Bitcoin way back in 2009. Twelve years ago, the idea of a decentralized person-to-person exchange with no entity controlling it was unimaginable, but the world was quick to understand and cryptocurrency evolved. But cryptocurrency wasn’t without problems. It soon became the breeding ground for hackers and was not decentralized in the actual sense. It was controlled by entities that built them. This necessitated a decentralized exchange (DEX) – a space to exchange funds without relinquishing control over them.

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Decentralized Exchange essentially is a means to exchange cryptocurrency in a peer-to-peer fashion without the need of an intermediary. Although the development is still underway, the idea of a decentralized exchange is revolutionary. To achieve such a feat was unimaginable till only a few years ago, yet here we are looking at a future with a decentralized exchange. But before we look into the future, let us see where it all began.

The Beginning

NXT Asset Exchange was one of the first decentralized exchange systems. NXT asset exchange used NXT digital currency to create assets. The system of creating assets on pre-existing blockchains was called ‘colored coins’. Since Decentralized Exchange was still at its nascent stage, direct asset-to-asset trading was yet to be made possible. Most assets could be traded for NXT coins. Colored coins also could only be sent to wallets that followed the Open Assets Protocol.

Counterparty introduced their Decentralized Exchange that improved the colored coins. Counterparty, where trading was also limited to only Counterparty assets, did not tie its tokens to the BTC balance of any given address. But Counterparty transactions took time since all buy and sell orders were escrowed to Counterparty automatically.

The first-generation Decentralized Exchange was still a work-in-progress. Then, Blocknet announced Block DX. Blocknet understood the need of the hour. It built a Decentralized Exchange with decentralized capital deposits, order broadcast, order matching, and the exchange of tokens while upholding the principle of transparency.

Blocknet’s new protocol paved the way for the development of Decentralized apps (dApps). The first app was called Block DX.

Decentralized Exchange Generations

Once the potential of Decentralized Exchanges was known, different players joined in the exploration and development process. Each kind of Decentralized Exchange has been divided into three generations:

First Generation Decentralized Exchange

The first-generation Decentralized Exchange was dependent on currency and chain. The first generation saw a Decentralized Exchange that used colored coins but wasn’t completely decentralized. In this form of Decentralized Exchange, one had to deposit coins for a token to trade which required the depositor to trust an intermediary to redeem their coins laters. So, this first-gen Decentralized Exchange failed in completely decentralizing the system.

Second Generation Decentralized Exchange

The second-generation Decentralized Exchange was dependent on smart contracts and Ethereum.  Ethereum was introduced in the second stage of the Decentralized Exchange. Ethereum facilitated Smart Contracts. The users could deposit tokens into a smart contract to perform a trade. Ethereum is more flexible but is not without limitations.
Ethereum smart contracts that run on the Ethereum blockchain trading with non-Ethereum tokens are not possible. One is only allowed to trade through smart contracts if their funds are deposited in a smart contract. The same goes for withdrawing funds as well. Engaging these funds in other use is also difficult since withdrawal takes time.
The smart contracts are also subject to bugs and hacks. Moreover, Ethereum exchanges require the use of the Metamask wallet to trade which are susceptible to hacks. Smart contacts are also slow which was sought to be addressed through the centralization of order books on the server. They also required the need to log on to the etherdelta website.

Thus, these systems were not completely decentralized because there was still a third party involved.

Third Generation Decentralized Exchange
The third generation Decentralized Exchange is based on protocols and currency agnostic. The third generation of Decentralized Exchanges is built on or uses a protocol. A protocol is an open standard on which developers can build and customize. It allows value to be assigned to whatever token they choose that utilizes that protocol.
The popular 0x protocol was designed to allow two or more parties to more easily communicate with one another in the Ethereum network. It helped to decentralize the process. On 0x protocol, off-chain orders are relayed to the chain so they can be settled on-chain. ‘Relayers’ manage the off-chain order book but do not execute any trades.

 Fourth generation Decentralized Exchange

The fourth-generation Decentralized Exchange is not only protocol-based and currency agnostic, but also fully decentralized. It is not limited only to specific blockchains. Many like to believe that this is the first Decentralized Exchange since the earlier generations always had an intermediary or a centralizing authority.

The fourth-generation Decentralized Exchange will be completely decentralized and will require no third-party interference to facilitate trade. The new Decentralized Exchange connects traders from the wallets to the coins being traded. The individual in a Decentralized Exchange will have complete autonomy over their funds that will help in efficient exchanges. The elimination of a third party will fix the problems of skepticism that are caused while entrusting a medium with your funds. Peer-to-peer exchanges will also significantly reduce the chances of hacks and leaks of personal data.

As the world progresses towards financial freedom and autonomy, Decentralized Exchanges are destined to play an important role in making the dream a reality. With easy transactions, direct and quick transfers, no intermediaries, and transparency, Decentralized Exchanges are here to stir things up and possibly for the better.

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