[continued from part II]
Reliable execution matters
The preceding discussions suggest it is possible in principle to exchange cryptocurrency across different blockchains, without calling on a trusted third-party to hold funds in escrow. (Or viewed another way, the blockchain itself is the trusted third-party equivalent, its immutable rules guaranteeing all-or-nothing fair exchange where neither side can cheat the other.) That however is not enough to achieve feature parity with existing marketplaces. It provides only one piece of the puzzle: arranging for settlement of funds after a trade is agreed upon. The problem statement made a leap of faith in assuming that Alice and Bob already found each other, and somehow came to an agreement on price/quantity. But that arguably is the raison d’être of markets: helping buyers and sellers locate each other while facilitating price discovery. In realistic equity markets, such arrangements of crossing buy/sell orders can take far more complex forms than pairwise arrangements. For example it is very common for an order to be executed piece-meal: when Alice places an order to sell 10BTC, some fraction of that order is paired with Bob while the remainder goes to Carol. These can even take place at different times; Alice has a partially-executed order in the interim before Carol shows up, and she could even cancel the remainder.
Meanwhile accurate price discovery depends on reliable trade execution. Suppose the exchange stopped at matching Alice and Bob, delegating the actual trading for the individual parties to work out. Imagine Alice and Bob each receiving an email: “Congratulations, we found a counter-party for your trade. Here is their contact information.” At this point there is no guarantee that settlement will take place. If Alice or Bob back-out—which does not violate the fair-exchange property as long as neither side delivered anything—this trade did not occur as far as the market is concerned. That means the bid/ask quotes come with a prominent disclaimer: you can buy/sell at this price as long as your counter-party is in the mood for executing the settlement. This is very different from the expectation of trading in equity markets: if there is an order on the book to sell 10 shares of Google stock at a specified price, and a buyer shows up offering that exact price/quantity, there is very high confidence that this trade will execute. (In fact one of the main objections to high-frequency trading popularized by accounts like Flash Boys involve edge-cases where those guarantees are weakened due to order- spoofing and phantom liquidity: seemingly available trades disappearing when somebody attempts to take advantage of it by posting the corresponding buy/sell order.)
In principle, trade execution can be incentivized in a P2P exchange by creating an economic structure of rewards and fines. Customers who bail out on the settlement can be forced to pay additional restitution to the exchange or their counter-party. In some cases the guilty party is easy to determine. Fair-exchange protocols that leverage the blockchain can be audited publicly. Anyone can observe its progress and determine who backed out at which stage. But turning this into a fee/reward structure already requires creating a financial dependency between the exchange and its customers. For example, customers may have to post bond as insurance against abandoned trades.
Second there is still the problem of friction and delays introduced by forcing every trade to hit the blockchain. In a traditional exchange, when Alice and Bob swap BTC for ETH that trade is not reflected on any external blockchain. Only an internal ledger reflecting their balances is updated. Requiring all such transactions to execute on-chain both introduces delays and aggravates the scaling challenge, particularly in the case of Bitcoin which is already facing acute congestion while proposed solutions are mired in political gridlock. (Ethereum is relatively fast with block times measured in seconds and plenty of room in blocks to accommodate expanded usage.) At its current capacity, the network has an estimated total capacity around ~7 transactions per second. By comparison roughly 1 trade per second occurred for USD/BTC alone on major exchanges over the last thirty days. If all of that activity were reflected on the blockchain, it would account a significant fraction of overall capacity and further strain the overloaded network. And that is just one trading pair among many currencies for which BTC markets exist. Not to mention variable fees that must be paid to miners for moving bitcoin on chain, compared to the efficiency of updating an internal ledger.
Unless settlement is immediate and guaranteed, at best Alice and Bob have something akin to a futures contract in place. Each is promising to deliver some asset (BTC or ETH) at a future time for a price agreed upon today. That price is not an accurate reflection of present BTC/ETH price: neither party is guaranteed to receive their BTC or ETH immediately at that price. Especially for volatile assets such as cryptocurrency where price can fluctuate widely in a short span of time, this is an important consideration. Paradoxically such high volatility can encourage parties to back out of settlement if they have the chance. Suppose Alice agreed to sell 1 BTC for 20ETH but while she is working through the peer-to-peer settlement process with Bob, a spike in BTC price makes her assets now worth 21ETH. She has every incentive at this point to walk away from the trade and seek an alternative buyer at the improved price. Meanwhile Bob who assumed that he had a deal to exchange his ETH for BTC discovers that the offer was a mirage. Without a forcing mechanism to guarantee timely (ideally, real-time) settlement of trades, prices quoted on the order-book become an unreliable indicator of supply/demand.
Granted none of the preceding implies that a fully decentralized, trust-free exchange with real-time settlement can not exist. It simply points to the chasm that exists between current attempts to replace the traditional exchange model, and places the problem of settlement—which may well turn out to be the easy piece—in context with the full spectrum of functionality that full-fledged market places are expected to provide. There are many challenges and open problems involved in designing a solution that can reasonably compete with the existing paradigm.