In DeFi there are two primary models used for trading: order books and automated market makers (AMMs). Let’s dive into the difference between the two and why it matters to crypto traders looking to better understand the ecosystem.
What are Order Books
An order book is a real-time, organized list of buy and sell orders for a given asset. Order books dominate the space, powering major project like Robinhood, Coinbase, or Binance. Order books show the amount and price at which users are willing to trade, matching buyers and sellers directly. This model mirrors traditional financial order books which harken back to the early 1900s and are used in nearly all centralized platforms.
Advantages of Order Books
There are many reasons, besides being a legacy product, that exchanges would opt for an order book. Order books provide:
- Price Precision: Traders can set specific buy or sell prices, allowing for precise control over trade execution.
- Market Depth Transparency: Visibility into the volume of buy and sell orders at various price levels aids informed decision-making.
- Reduced Slippage: High liquidity in order books can lead to minimal price impact when executing large trades.
- Advanced Order Types: Supports complex trading strategies through limit, stop-loss, and other advanced orders.
- Price Discovery: Allows price discovery for assets on the exchange, rather than entrusting an oracle to rely on larger CEX pricing data.
Automated Market Makers (AMMs)
While order books give precision, they require constant matching and high throughput. When DeFi products began taking off on Ethereum, throughput was majorly constrained by the non-scalable base layer. These constraints forced developers, like those at Uniswap, to reinvent how an exchanges match prices. The invention was AMMs. Instead of individually matching orders, AMMs utilize liquidity pools or token reserves often supplied by users. Prices are determined algorithmically based on the ratio of tokens in these pools, allowing for continuous, automated trading.
Advantages of AMMs
As the new kid on the block, AMMs have become popular all over the crypto space and for good reason. AMMs allow for:
- Accessibility: Enabling anyone to become a liquidity provider, earning fees in return, democratizing market-making.
- Continuous Liquidity: Liquidity pools ensure that trading can occur at any time, independent of individual order placements.
- Range of assets: Given any one can create a market for any coin, AMMs are a great home for the long-tail of assets to trade on - including less liquid or more risky assets such as memecoins.
Potential Drawbacks
As with most things, AMMs also have a range of potential drawbacks including:
- Impermanent Loss: Liquidity providers may face losses if the relative prices of pooled tokens change significantly.
- Price Impact: Large trades can lead to price deviations due to the impact on the token ratio within the pool.
- Price Inaccuracy: AMMs may not always reflect real-time market prices, especially during volatile conditions.
- Performance: AMMs are less performant than orderbooks, and have yet to scale successfully for perp contracts.
- Complexity: Most users do not provide liquidity, this has become dominated by market makers. AMMs also pose additional risk with respect to MEV(Maximal Extractable Value) - the liquidity providers could lose money and the traders can get worse execution than traditional orderbooks.
Conclusion
Both order books and AMMs offer popular and performant ways to match orders and allow for asset trading. Order books provide precision and transparency, appealing to traders seeking control and advanced strategies. AMMs offer accessibility and continuous liquidity, fostering a more inclusive spot trading environment of more risky assets.
While both serve specific needs, perpetual DEXs, like Perpl, typically opt for an orderbook to take advantage of the high throughput and tighter spread they can provide.
