Since the invention of writing, humankind has used order books for commercial transactions. Even 4,000 years ago, Mesopotamian merchants used them to maintain their goods, sales, and revenues.
In contrast, the introduction of DeFi in recent years has represented a significant departure from the previous method of operation. Decentralised Exchanges (DEXs) make it possible to exchange billions of dollars with nothing but mere code.
This is the Automated Market Maker (AMM) model.
AMMs have elevated the DeFi ecosystem, allowing anybody with an internet connection to trade cryptocurrencies with no limits, no KYC (no obligation to provide legal identification), and rapid settlements.
On the other hand, centralised Exchanges (CEXs) have maintained their significance due to their user-friendliness and professional trading tools, two elements associated with order book-based Trading.
Though decentralised Trading has gained immense popularity in recent years, it is a distinct procedure from regular exchange order books.
What are Automated market makers (AMMs)?
Automated Market Makers provide permissionless, non-custodial, and automated Trading of cryptocurrencies; for example, Uniswap.
Uniswap. Image: CoinCulture
AMMs handle all transactions automatically, without depending on third-party buy/sell requests, unlike order book exchanges where customers submit orders and wait for them to be completed.
AMMs use liquidity pools and an algorithm that determines token pricing depending on the fluctuating ratio of tokens available.
Liquidity providers (LPs) donate tokens to liquidity pools in exchange for trading fees proportional to the amount of liquidity they’ve contributed.
The smart contract automatically delivers these tokens to the relevant liquidity pool and exchanges them for the other tokens in the pair when transactions are launched on an AMM.
One of the hazards that LPs face while providing liquidity on AMMs is a temporary loss, which occurs when deposited tokens lose value owing to price fluctuations between the two assets in the pair.
Since AMMs cannot automatically balance token exchange rates, arbitrageurs are required to achieve parity between the values of tokens on AMMs and external marketplaces.
Once the token values rebalance, the loss is eliminated. However, withdrawing tokens from the pool when the prices are skewed would result in permanent loss.
What Are Traditional Order Books?
CEXs have order books that record all current trading activity and provide significantly more sophisticated functionalities than AMMs.
For instance, Coinspot is a centralised cryptocurrency exchange that uses its own order books and liquidity for users that buy, trade or sell digital assets using the ‘Market’ platform. They display separate parts for buyers and sellers, with the sellers’ section consisting of asks, the buyers’ section having bids, and the current market price of the asset being traded.
They also permit users to create limit orders, in which the price you wish to purchase or sell an item is predetermined.
Once the item reaches your specified price, the order book will automatically execute the deal for you. This strategy is beneficial for individuals who don’t trade frequently or don’t have the time to monitor market activity.
Traditional centralised exchanges often provide considerably larger volume and liquidity and a broader selection of tokens and trading pairings. Consequently, traders choose to trade on these exchanges to obtain the highest price with minimal impact.
On a popular CEX, inadequate liquidity occurs infrequently, and when it does, the problem is quickly remedied by the exchange.
Conclusion
These two approaches to designing exchanges have distinct advantages and disadvantages.
Order book exchanges dominate the market for bigger cryptocurrencies such as Bitcoin and Ethereum.
Conversely, AMMs assist consumers in obtaining the optimal price for coins with limited liquidity.
In addition, AMMs have enabled LPs to leverage existing liquidity holdings to achieve even better capital efficiency – we believe this is a significant advantage.
