🐈‍⬛Background

Types of DEXs, DEX vs CEX

Since the inception of Uniswap, other AMM designs have emerged, recognising that the product of two tokens, X and Y, always equaling a constant, K, is not always the most efficient trading strategy — i.e., x*y = K . Although there are many comparative advantages that DEXs hold over centralised exchanges, most notably greater security and opportunities for community building among token holders, AMMs are imperfect.

AMMs have a host of issues

--> Capital inefficiency; since most of the trades are executed within a narrow range of price levels unless the market is extremely volatile

--> There is a risk of high slippage for large orders due to small liquidity pools

--> The price is set based on a predetermined algorithm that may not always accurately reflect the current supply and demand for an asset.

--> Higher risk of front-running compared to the CLOB trade execution model. This affects liquidity provision.

Orderbooks address these issues

Creating a highly liquid marketplace for trading securities or digital assets requires different trading infrastructures. In traditional centralized securities markets, the order book is the most efficient and established trading mechanism. Order books are comprised of different buyers and sellers submitting trades to a centralised database. The limit prices of these orders make up the bids (buyers) and asks (sellers) on both sides of the order book. Since the liquidity of a security or other asset is dependent on the distribution of these asks and bids, third-party individuals or institutions may come in and place their own trades to close the gap between the ask and the bid. Closing this gap and filling orders by buying at the bid and selling at the ask is how market makers increase the liquidity of an asset on the centralized order book model. In other words, market-making makes it simpler for traders and investors to purchase and sell, facilitating a smoother flow of the financial markets and thus increasing the liquidity of the market.

Order books can maintain low slippage irrespective of trading volume, as traders can set limit orders. traders can set limit orders, which are orders to buy or sell an asset at a specific price or better. These orders remain in the order book until they are executed or cancelled by the trader..When a trader sets a limit order, they are essentially adding liquidity to the market by showing their willingness to buy or sell at a specific price. This can help reduce slippage, as the market can match the order with a corresponding order at the same price level.

In a centralised order book exchange, buyers and sellers can submit orders and interact directly with each other, which helps to establish the market price of an asset based on their collective actions. However, in an AMM, the price is set based on a predetermined algorithm that may not always accurately reflect the current supply and demand for an asset. Thus, the CLOB model has a much lower risk of front-running compared to AMM model. Many centralised CLOB based exchanges (CEXes) already implement a model similar to just-in-time liquidity - your trading balance is only debited when your order is filled. To make DEXes competitive with CEXes, including liquidity abstraction methods, such as just in time liquidity, is imperative.

DEX Dominance is Rising

With failures in many centralised exchanges, and the simultaneous rise in platforms capable of supporting high throughput, on-chain exchanges, is leading to a golden age for DEXes. As the important core features (such as liquidity abstracted CLOBs) become implemented on chain by DEXes, we anticipate a CEX-DEX flippening in the near future.