Reasons to Invest in Decentralized Exchanges

Most global cryptocurrency trading is conducted through centralized exchanges like Coinbase, Binance, and Bittrex. These platforms manage users’ assets and private keys and facilitate trading activities. However, several high-profile security breaches have resulted in substantial financial losses in recent years. Unfortunately, it appears unlikely that this issue will be resolved shortly. As software and hardware systems become increasingly complex, the probability of security vulnerabilities, such as the recent Meltdown and Spectre exploits affecting Intel’s CPU firmware, will likely rise.

Decentralized Exchanges (DEXs) represent an emerging technology that enables cryptocurrency trading through a distributed ledger. Unlike centralized platforms, DEXs return control of funds and trades to the users, eliminating a single failure point. A notable consequence of this architecture is that it can render government taxation or asset seizure nearly impossible, which could have far-reaching implications for the global economic and geopolitical landscape.

However, DEX technology is still in its early stages and faces several limitations, including susceptibility to specific types of attacks. This article aims to explore the fundamental mechanics of a decentralized exchange.

EtherDelta and 0x

One notable project in this space is 0x (Zero X), which seeks to establish an open protocol for decentralized exchanges on the Ethereum blockchain. The project also conducted a token sale, launching its native $ZRX token, which currently holds a market capitalization of $542 million. (Note: I have a personal stake in this token.) The $ZRX token is intended to facilitate governance for intelligent contracts and protocols within the ecosystem.

The 0x project boasts well-defined concepts, a robust open-source codebase, and comprehensive documentation. Nevertheless, questions remain about how 0x plans to generate sustainable revenue from decentralized exchanges and whether a market capitalization of $542 million is justified.

Upon reviewing the 0x whitepaper, it outlines a refined version of the EtherDelta decentralized exchange. EtherDelta, which operates primarily on the Ethereum network, was one of the first DEXs to gain traction. The latest iteration of its smart contract currently holds approximately $1.4 billion USD in assets, which is impressive given that its user interface remains challenging even for experienced tech enthusiasts.

Gaining a deep understanding of how the EtherDelta exchange operates is crucial for comprehending the current state of decentralized exchanges and the foundational principles behind 0x. In essence, 0x is an enhanced version of EtherDelta, offering improved code and additional functionalities.

The EtherDelta Smart Contract

Ethereum smart contracts are programs that execute on the Ethereum blockchain in a decentralized and immutable manner. The fundamental logic of EtherDelta and other Ethereum-based exchanges is embedded within these smart contracts. Developing such contracts is akin to launching a spacecraft, and they must be meticulously designed and highly secure, as even minor bugs can lead to significant financial losses.

These smart contracts are typically written in a programming language called Solidity, designed to be human-readable. However, once written, the Solidity code is compiled into Ethereum Virtual Machine (EVM) instructions, which are nearly impossible for humans to read directly. Some projects choose not to disclose their Solidity code, relying on "security through obscurity" to protect against potential exploits. For instance, the CryptoKitties genetic diversity smart contract is considered a “closed source.” Nonetheless, it is theoretically possible to reverse-engineer the operations of a smart contract, so one should always approach closed-source contracts with caution.

However, the Solidity code for the EtherDelta smart contract is publicly accessible on Etherscan. Below, we will analyze the two primary components of this contract: Fund Management and Trading Logic.

Fund Management

One of EtherDelta’s distinguishing features is that it gives users complete control over their funds. However, users must transfer their assets into the smart contract to use the platform. Although these funds are pooled within the contract, they are tracked transparently on the distributed ledger, maintaining user control. This process may seem complex, but the key takeaway is that users can deposit or withdraw their assets anytime without requiring approval from a third party.

As illustrated in the accompanying code snippet, there are two distinct mechanisms for moving funds within EtherDelta. One handles ETH—the native currency of Ethereum—while the other manages ERC-20 tokens. Most ICOs and tradable tokens today conform to the ERC-20 standard on the Ethereum blockchain, which provides standardized methods for their transfer and management.

In the provided code, only one of these methods is marked as "payable," a safeguard in Solidity that explicitly allows the transfer of ETH to a specific function call. In contrast, the `deposition` function for ERC-20 tokens requires an additional authorization step to transfer these tokens into the smart contract.

Trading Logic

EtherDelta allows new market orders to be stored either on-chain or off-chain. An on-chain order is stored directly within the smart contract, while an external party, such as a centralized server, manage an off-chain order. In practice, EtherDelta does not store any orders on-chain due to the high costs and slower transaction speeds associated with such storage. Instead, a more efficient mechanism is employed, which leverages off-chain order management to facilitate trading.

Conclusion

We have explored the fundamental components of a decentralized exchange (DEX) operating on the Ethereum blockchain. The 0x project builds upon these basics, introducing enhancements such as open standards for off-chain order management, thoroughly tested and well-documented smart contracts, and additional trading mechanisms. However, at its core, the underlying processes and cryptographic principles remain consistent with those used in traditional decentralized exchanges.