The Future of DeFi: Market making and order books
Automated Market Makers have been one of DeFi’s most fundamental and breakthrough innovations, proven by the immense popularity (and trading volume!) of AMM-based decentralized exchanges such as Uniswap or Bancor. What is the next step?
By pooling liquidity and always providing traders with a price quote, AMMs became a technical solution to the liquidity problem that early DeFi apps have been struggling with. But are on-chain AMM-based systems truly sustainable long-term and will they be able to outcompete order book based exchanges?
In this article, we make the case for a more diverse landscape of market makers that will compete using off-chain order books. Let’s dive in!
The importance of information for making markets
AMM-based exchanges are interesting for DeFi users because they don’t need to worry about order books when trading. Instead of analyzing the order book, they get a price quote based on the pricing algorithm that is implemented. Combine this with the benefits of a DEX (eg. no KYC and deposits) and you end up with an easy and fast solution for token swaps that amassed massive trading volumes and fees. The fees are distributed to liquidity providers that have pooled their capital to collectively act as counterparty, earning passive returns on their capital. Sounds like a win-win, right?
Before we draw that conclusion, let’s consider that price quotes on an AMM-based exchange are created through a very simple pricing algorithm which does not take into account any external information regarding the price and other factors. Liquidity providers that pool their capital in an AMM-based exchange “make markets” by always trading against the prices set by the AMM's pricing algorithm, essentially acting as uninformed market makers.
Let’s use an example to further explain this. When an informed market maker (eg. a hedge fund, centralised market-maker, etc.) acquires bearish information about a particular asset, it will immediately act upon that information by adjusting its outstanding orders in the order book. Automated market makers like Uniswap, Curve or Bancor will not adjust prices based on available information. Instead, arbitrageurs will change the token allocation of the liquidity pools of these systems to correct price quotes towards the market price. In this process, liquidity providers (investors)of the AMMs indirectly pay the arbitrageurs and incur (impermanent) loss in the process.
Information is crucial in financial markets, and professional traders or institutions will spend millions just to be located closer to the stock exchange and have access to the most stable and fast optical internet cable. The tiny edge of receiving information a split second earlier than competing firms can make the difference.
Recently the 1inch team made an excellent analysis on this topic and concluded that in today’s volatile DeFi markets arbitrageurs make a lot of returns on liquidity providers on AMMs. In volatile markets, informed market makers will always outperform uninformed market makers because there is less opportunity for arbitrageurs.
The need for diversity in market makers
In mature financial markets, informed market makers outnumber uninformed market makers simply because they are more profitable by adjusting their trades based on relevant information. While some information is straightforward (eg. significant price changes on other markets), some types of information need to be interpreted. The interpretation of information by informed market makers is done subjectively, based on their market opinions and appetite for risk.
In traditional finance, we see a diverse landscape of market makers, hedge funds, and algo-trading companies that all adopt trading strategies like bullish, bearish, long volatility, short volatility, focussed on tail risks, etc. Based on the risk they take and the quality of their information sources, market makers would make varying returns on their capital and would compete with one another on order books of various exchanges. This organic competition between participants is what makes a market efficient and liquid, and there is nothing wrong with this dynamic.
There are many ways to Rome; there are many ways to increase your returns by accepting different risks.
With AMMs in DeFi today, we don’t have a diverse set of market participants with varying strategies. Instead, we have one (automated) player that deploys capital of its liquidity providers. Liquidity providers earn high returns on their capital today due to limited competition and liquidity mining rewards, but once more advanced players start deploying their trading strategies in DeFi markets we will see them vastly outperforming liquidity providers of uninformed AMMs. Another interesting phenomenon to observe is the rise of a new generation of AMMs that implement a basic trading strategy in their pricing algorithm. An excellent example is Mooniswap, launched by the 1inch team, which should outperform Uniswap in high volatility markets.
Off-chain order books as the arena for market makers
So far we have learned that DeFi today has too little diversity in supply-side liquidity, and market makers could find better returns by adopting informed trading strategies. Once the market matures, we will see more diversity in market makers that will compete for alpha. Where will these market participants meet one another?
We need a place for these players to be arranged for traders to trade against. Although DeFi birthed a lot of interesting new concepts, such as AMM-DEX aggregators, we don’t expect order books to be replaced in the long term. It’s an effective tool for arranging market participants and DeFi should not reinvent the wheel here.
In mature financial markets, market making is automated and the speed of information is one of the facets that allow for competition amongst participants. If we want DeFi to become an attractive alternative to traditional finance, we need lightning-fast order books and blockchains inherently cannot meet this demand since they are designed for data redundancy—not even the fanciest new blockchain networks. In decentralised financial exchanges, order books should be implemented off-chain.
Opium Protocol uses meta-transactions for order matching and will migrate to more scalable Layer-2 tech in the near future. dY/dX and 0x have implemented similar mechanics. FTX’s Serum DEX seeks to implement a hybrid model, and Kyber is exploring some interesting mechanics that combine liquidity pools with limit orders and other advanced features for order matching. These are just some recent examples of a clear sign that the DeFi ecosystem is moving away from on-chain AMMs to high-speed off-chain order books as the de-facto “arena” for market participants.
Conclusion
Although the DeFi movement has birthed some novel mechanisms and innovations, there is no need to reinvent every component of traditional finance and mathematics. Let’s not reinvent every wheel of the wagon but instead leverage those components that work well and combine them with the benefits of decentralized technology. There is nothing wrong with order books, yield curves, and algorithmic trading as we know it today. The future of DeFi markets will be made by advanced market makers, using off-chain order books DEXs.
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