DEX v. EX - Unqualified Opinions #21

let's look at exchange infrastructure


  • Follow-up post from Eric’s DEX post (UO #10), but from a quant trader’s perspective. Qiao says it will be nearly impossible for decentralized exchanges to become as liquid as centralized alternatives. In fact, it may be physically impossible. Let’s go full-on crypto Flash Boys and discuss the impact of “latency” on liquidity. In DEX, a global network of thousands of nodes has to reach consensus, whereas centralized exchanges only use one server. All else equal, centralized exchanges will dominate DEX. (Of course, all else is not equal.)

DEX vs. EX (Latency & Liquidity) - Unqualified Opinions #21

In a previous issue of Unqualified Opinions, Eric discussed the current state of decentralized exchanges. The gist?

DEX liquidity today is orders of magnitude lower than that of centralized exchanges.

This can probably be attributed to a few challenges that decentralized exchanges are facing. The user experience is still not great (the tech is in its infancy). DEX alternatives face the same scalability challenges as their underlying blockchains. And perhaps most importantly, being the “second movers” (behind centralized exchanges) makes it difficult for them to hit critical mass and bootstrap strong network effects.

While all these challenges are all solvable, it will still be nearly impossible long-term for decentralized exchanges to become nearly as liquid as centralized exchanges. In fact, it’s physically impossible.


It comes down to the impact of latency on liquidity.

Latency in trading refers to the time it takes between a trader sending a message to the exchange and the exchange receiving it. And vice versa.

There are different types of messages. For instance, the trader can send a message to the exchange to place an order. Or the exchange can send the trader an update of the latest order book activity.

All else equal, traders will prefer to go to the exchange with the lowest latency. That’s because lower latency means you get faster information, and faster information leads to better trades simply because you can fill your orders before your competitors.

To illustrate this, picture a hypothetical scenario where exchange A publishes market feed instantly, and exchange B publishes market feed with a one day delay. Intuitively, would you ever trade on exchange B?

That’s of course a pretty extreme case. What if, more realistically, the latency difference between exchange A and exchange B was on the order of milliseconds (one thousands of a second) or even microseconds (one millionth of a second)? In this case, most traders probably don’t care about the difference. But one group of traders certainly do.

The automated high-frequency market makers.

HFT market makers trade frequently in order to capture tiny inefficiencies in the market. A few milliseconds or even microseconds of latency difference can make a huge difference for them. And these market-makers are ultimately responsible for the biggest share of the total trading volume. Latency is one of the most important factors that determine the liquidity of an exchange.

This isn’t a business, regulatory, or UX issue. It comes down to physics.

Decentralized exchanges have to reach consensus among a global network of thousands of nodes, whereas centralized exchanges only use one server. The latency of decentralized exchanges is limited by the speed of light, which takes more than 130 milliseconds, or 0.13 seconds, to travel around Earth. Seems small, but this is too big of a difference for the most sophisticated market-makers to ignore.

[TBI Note: Flash Boys was a good book. But if you want to wait for the movie, it will be on Netflix soon, apparently. We’re gonna try to get them to cast Qiao for the bathtub scene cameo where he can explain co-location and rebate arbitrage.]

Despite the latency disadvantages, what could drive volumes to decentralized exchanges? Well, where are a couple of major tailwinds for DEX.

  • Decentralized exchanges allow you to control your funds. They offer superior security to centralized exchanges, which are honeypots for hackers.

  • DEX is censorship-resistant. No signup or account creation. No KYC. No trading restrictions. Truly free and private exchange could be massive in jurisdictions where the rule of law is weak.

  • [TBI Note: We don’t condone or promote this, but an unfortunate reality is that many may use DEX (despite the illiquidity and price slippage) to evade taxes or Bank Secrecy Act provisions.]

These will be meaningful drivers of DEX growth.

But for market-makers, the risks may outweigh the rewards.

-- Qiao

P.S. Some fun stats: Latency on NYSE is about ~60 microseconds. And traders complain about it because NASDAQ has a latency of just ~30 microseconds (and shrinking). Traders pay millions of dollars for communication lines that link Washington DC (policy), New York (stock exchanges), and Chicago (derivative exchanges). Incredible amounts of money have been spent on optimizing data warehouses and fiberoptic communications lines. Market information travels between New York and Chicago in less than 4 milliseconds, for instance.

P.P.S. Smash those share and subscribe buttons, and spread the love. Tweet at me or Messari for feedback, comments, or (more?) questions.

News & Analyses

Messari Compression Algorithm

Content and thoughts from around the web as summarized by the Messari team.

❌ [Analysis] The decentralized threat to advertising – Peter McCormack

New threats to the advertising industry that arise from decentralization-inducing technologies (ex. crypto & blockchain) include:

  • Tech that blocks advertisers from promoting their lies

  • Tech that prevents advertisers from customizing their lies

  • Tech that prevents advertisers from knowing who they are lying to

  • Tech that blocks advertisers from tracking the performance of their lies

[TBI Note: Do you get the sense Peter doesn’t like advertisers?]

Ad companies will need a new model and framework to succeed in the decentralized web. The ad industry is collateral damage of the war between tech and privacy. (Messari | Source)

🌪 [Analysis] A storm is brewing over the largest Bitcoin exchange – Hasu

A series of recent issues with BitMEX has led to three concerns: 1) BitMEX may be trading against its customers, 2) BitMEX could be weaponizing its server problems, and 3) BitMEX may monetizes customer liquidations through its insurance fund. As BitMEX has financial incentives to take advantage of its customers, does not submit to any regulator, and has a quasi-monopoly, Hasu says it’s too easy for the exchange to make unethical decisions. He encourages the company to 1) rework the insurance fund, 2) associate a cost with continuous server overloads, 3) and return to the foundational idea of a peer-to-peer exchange. If BitMEX doesn’t currently benefit from unethical decisions, it has little to lose from implementing these changes that could make its business model more transparent. (Messari | Source)

Quick Bits (Don't read that, I read it for you)

Choke Points (Exchange News)

  • 📌 Coinbase adds support for stablecoin by CENTRE, a joint venture between Coinbase and Circle. Users of and related Coinbase apps had the ability to buy, sell, and transfer USDC starting today while additional support is planned for Coinbase Pro at a later date. (Messari | Source)

  • 🇸🇬 Singapore's sovereign wealth fund is investing in the world's largest cryptocurrency exchange, Binance. The venture capital arm, Vertex Ventures, of the government-run Temasek Holdings has made a strategic investment in Binance and will work with the exchange to set up a new branch in the city-state. (Messari | Source)

Startup Signals (ICOs, Cryptos, and Startups)

  • 🆕 Blockstack announced the anticipated launch of the first block of the Stacks blockchain, with the hard fork scheduled for Oct. 30. The fork aims to enable developers to build decentralized apps that can scale on the blockchain. (Messari | Source)

  • 🔐 ING Bank released its Zero-Knowledge Set Membership (ZKSM) solution at the Sibos banking conference. The Netherlands-based lender is known for adapting zero-knowledge proofs, which prove possession of a secret without revealing it, into simpler forms for use within the bank called zero-knowledge range proofs. (Messari | Source)

  • ⚡  Zeppelin, a startup that built an open-source library for secure smart contract development, announced the release of OpenZeppelin 2.0, an update release that features a stable API, 100 percent test coverage, and a full independent audit. (Messari | Source)

The Powers That Be (Legal/Reg/Policy)

  • Global Tech Exchange, an Australian initial coin offering project planning to raise as much as $50 million, announced its token sale has been halted by the Australia Securities Investments Commission (ASIC). The ASIC has stopped at least five ICOs since April 2018. (Messari | Source)

  • 👀 Chinese users will have to register their real names before they can use blockchain-based information service providers. Blockchain companies will also be mandated to censor content deemed to pose a threat to national security and store user data to allow inspection by authorities. The Cyberspace Administration of China published these draft regulations on Friday for public consultation until November 2 but it is unclear when these will be officially effected. (Messari | Source)

  • 📜 The Securities and Markets Stakeholders Group (SMSG), which advises the EU’s securities group recommended that the European Securities and Markets Authority (ESMA) consider crypto assets under existing rules—specifically, the MiFID II (Markets in Financial Instruments Directive II) regulations, which came into force in January. The reason was that transferable crypto assets used in payments are increasingly considered as investments and related risks are similar to those seen in the capital markets. (Messari | Source)

Did I miss something?

Send me the link, your twitter handle and your best imitation compression algorithm write up. If I like it, I’ll include your bit next issue (with attribution).

Community Updates

Podcast Recap

🎧 ICYMI, we also host & produce our own podcasts on Spotify, iTunes, and Google Play. In our latest episode, Katherine interviewed Blockchain Capital’s Spencer Bogart (disclosure: he’s a Messari investor) in SF. They chat about fund tokenization, benchmarks for crypto fund performance, and his transition from equity research to venture investing - something that might be interesting to our analyst community.

Some other great episodes are #9 (Tony Sheng on his writing proecess), #6 (Jake Chervinsky’s primer on federal & State crypto regulators), #4 (Nic Carter on data integrity in crypto), and #8 (Conversations on the ground at CryptoSprings).

Find our podcast series on Apple here, Google Play here, and Spotify here.

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