What exactly is 0x protocol and how does it work?

Rhys Muter 12 January 2018 NEWS

0x2 Exchange - ITI

0x protocol is a hybrid meeting market demands of greater security and greater access.

0x protocol, pronounced zero ex, is an Ethereum blockchain-based innovation the primary goal of which is maintaining a decentralised cryptocurrency exchange. That's a pretty heavy concept which will need unpacking to fully understand.

Previous exchanges have been vulnerable to hacking attempts leaving investors with no way to recover their cryptocurrency investments. This is because a centralised exchange which holds the assets, similar to how a bank might hold assets, presents a large and immobile target for technically advanced hackers.

For this reason, there is a growing demand for decentralised exchanges as traders move around the crypto economic cycle and begin storing assets in their own wallets, otherwise known as cold storage. The 0x protocol operates to meet that demand and address the security concerns common to most investors. The most important way that is resolved is by using an Open Order Book (OOB) to work as a relay between traders on the exchange.

Assets and the Open Order Book on 0x exchange

In addition to the convenience of having assets stored on a centralised exchange, this makes placing trades relatively simple for new entrants into the market. The 0x decentralised exchange seeks to address the concern of privacy while also maintaining an efficient means for investors to make transactions.

That is done in several ways. First, Investors are required to hold their own assets. An investor holding their cryptocurrency assets in their own wallet is the most efficient means of reducing risk. This has been seen with the Mt. Gox hack that left the exchange’s entire pool of funds lost.

Second, an actor on the network known as a relay node is used to make orders on the exchange, this is called an Open Order Book. The OOB is what is known as a market maker and its most important function is holding an order book.

That order book is used to match exchange participants who are looking to either buy or sell cryptocurrencies. The interesting thing for someone operating an OOB is that they are paid a fee for their services. The fee is paid in the native token of the 0x protocol which is ZRX.

It is in these two ways that the 0x protocol establishes a decentralised exchange. That definition of decentralised will be a little contentious for bitcoin purists. For the ordinary investor, being able to place their order on the Ethereum blockchain with the comfort of holding their own assets in the place of their choosing, means a level of decentralisation.

Role of the OOB on 0x exchange

In addition to that, the trader is completely dependent on the Open Order Book to secure the trade. It is believed that a successful trade depends on the OOB in two ways. First, the relay node must have the ability to conduct the trade.

That means that if the OOB experiences technical issues, any potential trade may not be conducted or at worst assets could be lost completely. Second, and most importantly, the OOB must have the willingness to make the transaction.

The trouble for the trader is that the open order book may choose to settle trades selectively which could harm a traders ability to enter the market at the time and price of their choosing. This leads to a range of issues for the broader governance of the network as the OOB maker could be a big market player and potentially, by virtue of the role as market maker, become a market manipulator.

Those concerns are yet to be proven valid or not and should not rule out the smooth functioning of the 0x protocol on the Ethereum blockchain because it will provide greater security and greater market access for the individual trader. This exchange may also be a step in the direction of being able to provide greater customer protection through government regulation in the future, which will be needed due to there still being some security issues to be worked out.

Security Vulnerability of 0x

The 0x protocol does have some vulnerabilities for the investor. Because a buyer and seller must communicate directly with the Open Order Book there is the possibility that the OOB maker could be a bad actor. In that case, the trader can be vulnerable to what are known as Distributed Denial of Service attacks or DDOS attacks.

DDOS attacks aim to overwhelm a network in order to disrupt its normal functioning. In this case that could be either a buyer or seller, assuming that the OOB relay node is the bad actor.

This risk can be protected against with the correct software and by choosing to trade with more reliable OOBs and that information will be available on the exchange platform. The risks this kind of cyber attack can have could lead to an investor losing the contents of their wallet.

It's for this reason that people often backup their wallet or store a majority of their funds on a separate wallet to the one they used for trading, thereby minimising the risk of a DDOS attack.

On blockchain processing vs off blockchain processing

The drawback of previous Ethereum blockchain-based exchanges has been that all orders have been entered onto the blockchain, and the more information being entered on the blockchain means the ability of the network to process blocks of transactions is harmed. This is because not only the financial settlement was entered but also the order posting, modifications to orders and also cancellations.

The 0x exchange differs in that the order posting, order modifications and order cancellations will not be entered on the blockchain; those requirements will be documented between the traders and the OOB maker.

The financial details such as transaction amount, payer address, and payee address will still be entered onto the blockchain. This will result in an increased ability for the network to process transactions in peak volume trading periods and, in theory, reduce trading fees.

As well as the positives of this innovation there are also some drawbacks. For the privacy oriented traders, personal information is provided to the OOB in the process of making the transaction and it should be assumed that the 0x exchange administrators will also have access to that information.

The trade-off here is greater convenience of trade for a reduction in privacy. Considering that this platform could be mostly used for speculative trading, that may not be so much of a problem to most users.

Will the 0x exchange be successful?

To conclude, the 0x protocol is an innovation that aims to address certain market concerns around security, market access and other areas.

There is a growing demand for decentralised exchanges and that demand is only set to grow throughout 2018 and well into the foreseeable future. The 0x exchange fills that demand on the Ethereum blockchain.

Based on that, it is likely that the exchange will be largely successful in 2018. But an investor would be well advised to be aware that these kinds of market innovations are very immature and have a long road of development ahead.

This could mean that the 0x protocol fails, but what is certain is that another decentralised marketplace will take its place until the market begins to settle on a workable crypto economic model. It may well be that the 0x exchange is that workable model, but only time will tell.

Where to buy 0x in Australia

Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific provider, service or offering. It is not a recommendation to trade. Cryptocurrencies are speculative, complex and involve significant risks – they are highly volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of future performance. Consider your own circumstances, and obtain your own advice, before relying on this information. You should also verify the nature of any product or service (including its legal status and relevant regulatory requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may have holdings in the cryptocurrencies discussed.

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