What is Exchange 3.0 and how did we evolve from the "Age of Mt. Gox" (Exchange 1.0), to today’s "Age of CEX/DEX" (Exchange 2.0), to the coming "Age of fair trading" (Exchange 3.0)?
How current crypto-exchanges bottleneck the crypto-economy
Crypto-exchanges need to evolve beyond their current limitations in order to avoid bottlenecking the crypto economy. In the next era of the crypto revolution, the tokenization of physical and virtual assets means coins will expand their role to become fractional ownership of valuable assets (eg. STO), not just currencies for speculation. This transition from an instrument of speculation to a vehicle of value means exchanges must protect coins with a higher level of security and fairness during trades.
Criteria of a good exchange
The standards for good exchanges are higher than the standards of good assets. In addition to secured ownership, exchanges must be fast and fully transparent to ensure fair trading. The criteria of a good crypto exchange can be summed up in three parts:
- Speed
- Security
- Transparency
Speed means transactions are executed in a timely manner to minimize price slippage. Security means traders have 100% custody of private keys, so there’s no risk of losing assets due to theft or accidents. We call the highest security standard Satoshi-grade security, which means users never drop custody of private keys at any stage of an activity, and everything is completely on-chain. Transparency means activities are auditable public records, which is especially useful against front-running.
These three criteria can only be achieved by building an end-to-end decentralized architecture on public blockchains, without sacrificing speed. Being decentralized end-to-end means every step -- from order-book matching to settlement -- is decentralized and secured. Being on a public blockchain means all activities are auditable public records, which guarantees transparency.
A good exchange must be able to do all of these without sacrificing speed. The degree to which an exchange can achieve these three criteria is a useful index of how well it will achieve fair trading.
How crypto exchanges are evolving
The following chart demonstrates how crypto exchanges achieve (or fail to achieve) the three criteria of at different stages of evolution.
Exchange 1.0: The age of Mt. Gox
Exchange 1.0 represents the earliest exchanges in the bitcoin era, such as Mt. Gox. In this Wild West environment, exchanges played the role of the town banks and hackers played the outlaw bank robbers. We saw many costly and significant hacks, including the infamous $500M hack of Mt. Gox in 2013-2014. The dominant exchange architecture was centralized but they weren’t fast; in other words, these early exchanges were never secure, fast, or transparent.
In the last few years, we’ve seen global players like Binance and Coinbase introduce an ambitious, international approach to CEXs and improved customer service and security.
Exchange 2.0: The age of CEX vs. DEX
Exchange 2.0 represents the current state of exchanges, where we've seen improvements in speed and security, but often at the expense of each other. For example, centralized exchanges (CEX) are fast but they aren’t secure, and decentralized exchanges (DEX) are secure but they aren’t fast. This trade-off has catastrophic consequences, because 99% of trades prioritize speed over security, so they are conducted on centralized exchanges, and in 2018 alone we saw more than $1B lost due to hacks.
Some new, successful exchanges manage to achieve both speed and security, but they ignore the transparency criteria by using off-chain protocols that rely on opaque liquidity pools or opaque relay networks to perform order-matching, which opens the risk for biased matching and front-running. Thus, the exchanges in the Exchange 2.0 era sometimes deliver speed, security, or transparency, but never all three.
Exchange 3.0: The age of Fair Trading
As an evolution, Exchange 2.0 has been highly successful. During this time, we’ve seen the value of the crypto-economy—if only as reflected by the market capitalization of bitcoin and alt-coins—increase more than a hundredfold since early 2017. Still, there’s a last-mile problem we need to overcome for crypto exchanges to achieve a higher standard of security and fair-trading.
Exchange 3.0 represents the future where exchanges are decentralized end-to-end on public blockchains and achieve all three criteria of speed, security, and transparency at every step of trading. This will deliver a trading experience that can only be described as fair trading, and it is characterized by three benefits:
- Sub-second, enterprise-grade trading speed, without sacrificing decentralization. There is no compromise between speed and security.
- 100% custody of private keys end-to-end from order-matching to settlement, along with a tamper-proof order-book, and decentralized cross-chain transfers.
- 100% auditable, on-chain order-book that can detect and prevent front-running. No one will have an insider-advantage during order matching, and all trades will be treated fairly.
A fair trading protocol will provide sub-second speed, Satoshi-grade security, and auditable transparency, from order-book matching to settlement.
We’re at the inflection point
To move toward Exchange 3.0, the industry needs to continue the innovation path of decentralization by decentralizing the order-book on a public chain without sacrificing speed. This is a large-scale performance challenge that few companies without the scale of Google or Netflix have the expertise to innovate. Fortunately, a handful of blockchain companies with deep technical expertise are taking on this challenge, and we’re not far from achieving Exchange 3.0.
The next evolution of exchanges—Exchange 3.0, the Age of Fair Trading—is coming.
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