Lately the Ethereum-based prediction market has accepted the challenge of creating a decentralized exchange on top of Ethereum. If exchanges are completely decentralized on a blockchain, the theory goes, they could offer near-real-time, peer-to-peer clearing and settlement with no single point of failure. Cool.
The team responsible for this initiative wrote extensively about the need for an automated market maker. They created a mathematical model that tests a method for adding liquidity as a bot – comp;letely automated.
But there is one little wrinkle. What happens if there was no liquidity in the exchange?
Unfortunately, low liquidity is a natural by-product of new technology. Early adopters are a small group. And because the exchange will be built on a blockchain, the number of active traders could be very small, indeed — as small as one or two traders.
This chart shows the potential for failure if the wrong model is applied to a one-to-one trading situation.
Since inventors are typically ahead of the curve, it is likely that blockchain exchanges will not succeed, initially, due to lack of liquidity. That’s another way of saying: “Nobody will come”. (Cue video of tumbleweed rolling down a deserted main street.)
There is a possible solution. If an exchange can cover all the squares in the matrix, then there is a glimmer of hope.
As developers, we should make many-to-many exchange capabilities a lower priority. Instead, we should concentrate on creating a process of negotiation between a single buyer and a single seller. That’s the logical starting point. Until we solve that problem, blockchain exchanges will be fighting an uphill battle.
The latest blockchain craze is ICOs – initial coin offerings. Coins are cryptocurrency units created to represent just about anything of value. They can have intrinsic value, such as a gold-backed coin, or simply represent an idea. Coins (a.k.a. “tokens”) are attractive to start-ups that want to raise capital completely bypassing the venture capital route.
ICOs are often managed in a blockchain. If they are on the Ethereum blockchain, transfers and assignments can be 100% automated. As of this writing, Ethereum seems to be the go-to network for creating and managing initial coin offers. One start-up, Bancor, raised an eye-popping $150 million. With results like that, it is no wonder that many start-ups are glammering to be the next big ICO.
So what’s preventing any rag-tag group from introducing the next $150 million coin introduction? Simply stated: lack of awareness. There is a proliferation of hundreds of other coins all competing for the same dollars. Throw in illiquid markets and you have what amounts to a marketing problem. As any good start-up knows, marketing is everything.
In the real world, initial public offerings of stocks require an investment banking firm acting as an underwriter, well-connected institutional investors and network of retail investors. It is very well established.
The ICO network, on the other hand, is not part of the mainstream. Some believe that it will never reach the expectations of experienced investors and that it will quickly crash and burn.
Tradefor takes a contrary view. We look forward to servicing the ICO market as a marketing tool that addresses pricing issues in illiquid markets. Start-ups will be able to offer both conventional financing offers and cryptocurrency offers in a unique adtech platform that features a growing network of interested investors.
As early proponents of the Ethereum blockchain, we imagined a world where stock exchanges could exist on the Ethereum blockchain without the need for a clearing firm or a settlement house. Trades would just be matched and cleared on a blockchain. Say goodbye to old-school clearing.
But despite the potential benefits of such a scheme, there are some serious usability issues that can’t be ignored. Matching orders will take minutes to confirm and the complexity of implementing a matching algorithm as a smart contract will, at best, result in many partial order fills that take more than sixty seconds to confirm. It all makes for a bad customer experience.
When building Tradefor, we concluded that a positive user experience is something that either makes or breaks any application designed for the mass market. Consequently, we built Tradefor’s front end using eminently-scalable Node.js. But we didn’t want to completely walk away from Ethereum, so we decided to use Ethereum as a means of providing an immutable ledger of electronic assets assigned to our users AFTER the trade has been executed.
In short, we built a hybrid Ethereum exchange. Holdings are updated on the Ethereum blockchain every six hours. Whereas, we admit that we are not a pure DAPP, we are able to deliver many blockchain benefits while providing a very unique and engaging trading experience. We can distribute any electronic asset, including gift cards and coin tokens, on the Ethereum public blockchain.
We will leave the pure exchange model to the purists.