The recent crisis in crypto markets has largely been one of transparency and accountability. Large, centralized entities such as Three Arrows Capital and Celsius have blindsided cryptocurrency investors and sparked contagion by taking on excessive risks behind opaque balance sheets and positions.
Meanwhile, the market chaos has provided a successful stress test for decentralized crypto exchanges, or DEXs. Platforms that operate with full transparency on the blockchain have functioned smoothly throughout the turmoil and volatility, providing a strong signal that DeFi is the key to a more sustainable future for crypto.
To really deliver on that promise, though, DeFi needs to evolve. The dominant DeFi platforms today suffer from several major shortcomings that have prevented them from going mainstream and deterred the entry of traditional financial institutions.
Nearly half of traditional hedge fund managers, representing $180 billion in assets under management, are considering investing in crypto. But they are unlikely to make the leap until DeFi can offer superior infrastructure that gives them the deep liquidity, fast transaction speeds, and order execution efficiency they demand.
Many of the limitations of today’s big DeFi exchanges stem from their reliance on automated market maker (AMM) systems. AMMs became the default infrastructure as a way around the shortcomings of Ethereum, the dominant DeFi blockchain. Because Ethereum is an all-purpose blockchain with relatively slow block times, it is impossibly expensive to update positions built on an on-chain orderbook. AMMs helped solve that problem through the creation of passive liquidity pools for trading pairs, allowing in theory a limitless number of trades without the need for active position updates. But in doing so, AMMs created market inefficiencies.
One is the risk of front-running attacks, which exploit the AMM liquidity pool structure via miners manipulating the order transaction structure within a block to maximize their revenues at the expense of whoever initiated a trade. This front-running, or Miner Extractable Value (MEV), activity has become endemic on ethereum-based DEX platforms, posing a major threat to trading performance and user confidence.
AMM exchanges also create the risk of impermanent loss, which can and often does destroy participants’ profitability. Impermanent loss works against liquidity providers when the price of their token pair diverges, leaving them with a lower value than if they had simply held the assets.
Third, DEX participants have to put up with significant price slippage that can eat into their profitability. The limited liquidity often found in AMM pools means that a large trade can move the price significantly, resulting in a worse than expected price.
The superior alternative to AMM is now starting to emerge as more DEXs adopt orderbook-based systems. The orderbook mechanism – which forms the core order matching engine of centralized exchanges – is more proactive and flexible than AMMs, allowing market makers to match individual buy and sell orders as they arrive. Traditional electronic financial markets have long been run on orderbooks, making it a battle-tested system with which hedge funds and other institutions are comfortable.
The emergence of much faster, cheaper blockchain protocols such as Solana and Cosmos has provided the technological underpinning for orderbook systems to function on-chain much more effectively than they can on Ethereum. The Cosmos technology stack, for example, allows for full blockchain customization that helps to reduce transaction fees to minuscule levels and speeds up block times, while reducing congestion and potential downtime.
Orderbook systems drastically reduce the chance of front-running activity because they don’t rely on open liquidity pools that allow MEV bots to get an advantage on traders. By the same score, they eliminate the phenomenon of impermanent loss. The deeper liquidity created by real-time price matching means there is far less chance of significant price slippage. orderbook systems allow participants to place pending orders at specific prices, giving them a level of confidence in making trades that is lacking on AMMs.
In other words, orderbook infrastructure allows DeFi to adopt all the great user experience and trading efficiency of centralized platforms, while maintaining the decentralization, transparency and security that have always been the sector’s main attractions.
Adopting the proven and trusted orderbook system will be a crucial step to taking DeFi mainstream in the coming years. That in turn will lead to a much healthier and resilient crypto ecosystem, lowering the risks of contagion caused by the shady practices that are proving to be all too common today.
(Dan Edlebeck is a co-founder of Sei Network, a Layer 1 blockchain with a built-in orderbook for DeFi products.)