The Return of the Order Book – How DEXs Have Come Full Circle
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These days, decentralized exchanges have become so popular that it’s hard to believe that the space barely existed only a few short years ago. According to DeFi Llama, DEXs are currently the most popular category of DeFi app by far, accounting for around a third of the total value locked and with the most number of operational dApps across all blockchain platforms.
The space has grown thanks to the immense popularity of automated market makers, the smart contracts underpinning most decentralized exchanges. But while AMMs have fueled the meteoric growth in the sector, they come with some critical limitations that could hamper their future expansion into the global capital markets. Could up-and-coming new DEXs wielding a central limit order book be the solution?
A Short History of DEXs
To understand the challenges inherent in DEXs, it’s worth taking a moment to reflect on their evolution up until this point. The desire for DEXs came about due to the many challenges and limitations facing centralized crypto exchanges. After the seismic hack of Mt.Gox in 2014 and following Ethereum’s launch in 2015, many in the crypto community were keen to explore non-custodial ways of trading crypto that didn’t involve having to trust a centralized entity with their funds.
So around 2016, the first iterations of Ethereum-based DEXs, including dApps like EtherDelta and IDEX, began to emerge. However, they faced several critical issues, mainly a lack of liquidity. These exchanges used the same order book model deployed in centralized trading platforms, so they relied on a steady stream of orders to create liquidity.
Unfortunately, Ethereum’s slow block times meant that it could take a long time for orders to be matched, making for a poor user experience. Furthermore, while centralized exchanges use market makers to keep markets liquid, Ethereum’s high gas fees ensured there was no profit in market making on these earliest DEXs. Another challenge was that tokens had to be listed in pairs, meaning that a user could end up navigating multiple pairs to complete their desired trade.
The Rise of the AMM
The solution to this problem eventually became automated market makers (AMMs), pioneered by projects like Uniswap and Bancor. Rather than relying on an order book to generate liquidity, these innovative new exchanges operated on the principle of liquidity pools.
The earliest iterations used smart contracts to facilitate swaps between pools with ETH as an intermediary token. So while the user trades token ABC for token XYZ, under the hood, the exchange trades ABC into ETH and the ETH into XYZ. Later iterations of Uniswap have done away with the intermediary token, allowing users straight swaps between tokens.
The introduction of AMMs, together with the emergence of decentralized lending apps like Compound, lit the touchpaper of the DeFi movement, which began to take off in earnest around late 2019. At the time of writing, there’s over USD 67 billion worth of liquidity locked in decentralized exchanges – numbers of which the earliest DEX operators could only have dreamed.
The Limitations of the AMM
As DeFi grows, it’s inevitably becoming more attractive to institutional investors. However, the AMM model is likely to become a stumbling block for many – precisely because of the lack of a central limit order book. The AMM model only allows a trader to swap tokens and specify the slippage that they’re prepared to tolerate. This makes for uncertain price and execution timing and doesn’t allow for more sophisticated trading strategies using limit orders.
As such, DEXs are coming full circle. In these more liquid markets, there’s a compelling argument for reintroducing the order book to support demand from new crypto projects, hedge funds, and high-frequency traders. Dexalot is an Avalanche-based exchange that aims to meet this demand. Dexalot allows traders to place limit orders fully on-chain, setting the size and limit price for their orders so they have complete certainty over the settlement price. If an incoming order matches an existing order in the book, it removes liquidity and executes immediately; otherwise, it’s added to the order book as a new maker order. Dexalot also supports partially filled orders.
As it’s based on Avalanche, Dexalot also addresses many of the challenges of the old Ethereum-based DEXs. Low fees, high throughput, and near-instant finality mean that traders get the same experience as a centralized exchange while removing many of the barriers for market makers.
Dexalot’s pioneering approach is likely to be a function of its team. With over four decades of Wall Street experience in the leadership group, as well as extensive expertise in entrepreneurship, they’re aiming to bring the professional experience of the financial sector to the DeFi space.
Poised for Institutional Growth?
DEXs may not have been around very long, but they’ve been the subject of endless innovation and development that’s stimulated their rapid expansion. Now, on the cusp of cementing their role in the world’s financial markets, the reintroduction of the order book could be the catalyst for another episode of stellar growth.