Decentralized exchanges (DEX) solved the middleman issue and helped traders swap cryptocurrencies quickly and with minimal fees. However, problems like liquidity persisted, and this gave birth to a DEX model called Automated Market Making (AMM).
Exchanges employing AMM claim this model solved the problem with a lack of liquidity. This model is definitely different from everything we’ve seen so far, but is it really better than the traditional order book model?
Let’s find out.
AMM & Order Book Explained
This chapter will explore both AMM and order book-based decentralized exchanges and list their respective advantages and disadvantages.
Automated Market Maker (AMM)
Decentralized exchanges are still young, and many platforms struggle with liquidity. Simply put, some crypto pairs are more difficult to exchange than others, and AMM aims to solve that.
Binance’s introduction to AMM uses a great metaphor to describe AMM — a robot that’s always ready to quote you a price when you want to trade two assets.
Well, crypto owners can actually invest their cryptos to provide liquidity in a liquidity pool. In other words, they become a sort of a market maker. In exchange for providing liquidity, they’ll earn money from fees on the exchange using AMM.
An AMM uses a mathematical formula that takes into account the current liquidity of a trading pair and gives an instant quote to traders. In other words, instead of referring to an order book to get a price, you’ll get it as a result of an algorithm.
How Does AMM Work?
Currently, the most popular exchange protocol that uses a type of AMM is Uniswap.
Order book-based DEXs use the traditional trading model, which has been around long before the rise of DeFi.
How Does Order Book Work?
Simply put, traders set buy and sell orders for an asset, and the order book would organize them by their prices. This means you can trade any asset as long as there are a supply and demand for it.
If you have some trading experience, the chances are you already used an order book.
Advantages and Disadvantages of AMM
The primary advantage of AMM is that there will always be liquidity for otherwise illiquid markets — at least while there are enough people to invest in a liquidity pool. AMM looks ideal for fragmented liquidity markets.
AMM offers better user experience as traders will always get a price without getting too much into the whys and hows.
However, liquidity pools aren’t that big in AMM DEXs at the moment, especially for less traded assets, resulting in high slippage if a large order is executed.
Slippage is a term used to describe how much the order’s size affects the ultimate price at which a token was bought or sold. This means that slippage will be low with small orders, but with large orders, slippage rises exponentially.
For example, if an order takes up half of the liquidity pool, colossal slippage would double the token price. Such massive slippage would never be acceptable in order book exchanges.
To keep slippage low, orders should, on average, take less than 1% of the liquidity pool, and that’s often not possible for AMM.
Moreover, Andrey Belyakov from Opium Network argues in a blog post that AMM markets act as uninformed, as the price is set by a pricing algorithm rather than an order book.
In other words, an informed market maker would always adjust orders in the book depending on the outside information that could cause the market to go bullish or bearish, but that’s not the case with AMM, as platforms such as Curve or Bancor will not adjust to that piece of information.
What will happen instead is that the arbitrageurs will change how tokens are allocated in these systems to make price quotes similar to the market price. This will cause investors (liquidity providers) to pay arbitrageurs indirectly and lose money along the way.
Advantages and Disadvantages of Order Books
If a market is liquid enough, order books are a perfect way to trade as slippage will remain low even when the trading volume is high.
The majority of centralized exchanges use order books, including the biggest ones such as Binance or Coinbase, as there’s currently no better model. That’s also the model that traditional stock exchanges use for trading, such as the Wall Street Stock Exchange.
However, if a market is illiquid, order books don’t really work. You can make an order, but finding a match for it won’t be as easy, and you’ll have to wait for a long time. This often means you’ll not be able to escape volatility and large spreads occurring in these situations
Order books also pave the way for market manipulation. For example, speculators often determine in which direction the asset’s price would go depending on clues from the order book. If a book hits a buy or sell wall, that could indicate that traders are looking to buy or sell an asset, respectively.
Manipulators often tend to abuse the order book and provide false clues for the market sentiment, causing many traders to make wrong decisions. Decentralized exchanges also give room for wash trading, pump and dump schemes, and more. That’s one reason why many traders don’t treat order books as the best choice for DEXs. Such behavior is usually punished in traditional stock exchanges, but nobody can punish you on a DEX where trading is anonymous.
Finally, order books allowed front-running. Even though it wasn’t widespread, some notorious examples put off many traders from using DEXs.
New Projects to Solve Existing DeFi Problems
The good news is that professionals in DeFi work hard on overcoming the problems posed by existing DEX design models.
Depending on the perspective, AMM is an upgrade compared to the order books, although it’s still a pretty young system that needs improvements.
Some platforms, such as OneSwap, are trying to get the best of both worlds by creating a hybrid exchange that incorporates both AMM and order book elements.
Final Thoughts: What is better?
AMM solved a considerable obstacle that has been the primary source of concern for many DEXs — illiquidity. However, it brought a set of new problems, such as high slippage and risks for liquidity providers.
Perhaps the best approach is to perfect these underlying design models (AMM, in particular) or offer an even better service to traders and liquidity makers. OneSwap and similar platforms are already working on this.
For the time being, we’d say that AMM won by a hair in this race. However imperfect, it has vast potential, and the continuous improvement has already resulted in significant popularity, as Uniswap (V2) emerged on top of CoinMarketCap’s top decentralized exchange list.