Cryptos’ attempts to distance and differentiate itself from traditional financial markets has taken another knock. This follows revelations that trading manipulation using high-frequency bots is rampant on decentralized exchanges (DEX) by researchers at Cornell Tech.
In a paper titled ‘Flash Boys 2.0: Frontrunning, Transaction Reordering, and Consensus Instability in Decentralized Exchanges’, the researchers have argued that despite the promise of blockchain technology being to bring about trading ecosystems that are fair and transparent, this has not been achieved due to the growing deployment of arbitrage trading bots:
“Like high-frequency traders on Wall Street, these bots exploit inefficiencies in DEXes, paying high transaction fees and optimizing network latency to frontrun, i.e., anticipate and exploit, ordinary users’ DEX trades.”
CENTRALIZED EXCHANGES ALSO EXPERIENCE FRONTRUNNING
The authors of the report, however, point out that practices such as frontrunning (where information asymmetries are exploited by those who have privileged access of user information) also exists in traditional exchanges and not just in decentralized exchanges.
In decentralized exchanges, the report says the information asymmetry arises when there are certain actors who hold an advantageous position with regards to the underlying infrastructure.
One technique that the bots use to frontrun user orders and cancellations is taking advantage of users’ typographical errors. On the Ethereum blockchain, for instance, some bots have specialized in profiting off the typos made by users.
TYPOS COULD COST YOU A FORTUNE ON DEXES
This has resulted in frustrated users posting public messages pleading with the arbitrageurs to send back cryptocurrencies sent in error. The authors of the report blame such problems on flawed exchange designs. They consequently point out the need for ‘carefully considered and formalized guarantee’ for decentralized exchanges.
Some of the decentralized exchanges that the researchers studied include Kyber Network, Token Store and Ether Delta.
According to Etherscan, based on the last seven days, Kyber Network had a DEX market share of 14.8 percent. On the other hand, Ether Delta and Token Store had a market share of 7.3 percent and 3.9 percent respectively.
A Validation of Satoshi Nakamoto?
In what may seem as a validation of Bitcoin creator Satoshi Nakamoto’s belief that miners have every incentive to stay honest and avoid behavior that undermines a blockchain and by extension the validity of their wealth, the Cornell Tech researchers did not find any collusion between miners and arbitrageurs.
While the authors focused on decentralized exchanges, they also noted that the problem could be much bigger in centralized exchanges. This is in light of the fact that decentralized exchanges have a much smaller market share of the wider market. To illustrate, the largest decentralized crypto exchange IDEX sits at position 129 among all exchanges by volumes, per CoinMarketCap.