AMM or Orderbook, that is the question!

The original text by 0xAlpha is reprinted on this page:

Why DeFi must choose AMM rather than orderbook


There have been plenty of discussions on AMM v.s. orderbook, most of which focus on the technical parts: capital efficiency, price discovery, etc. However, few seem to have realized that the battle between AMM vs orderbook is way more than just a technical choice of financial trading business. Orderbook is the technology adopted by the old “financial aristocrats”, a.k.a. Wall Street, to rule and expand their financial empire. In contrast, AMM is the fintech of the people, by the people, for the people!

Let’s look at three exchange trading scenarios, in which liquidity is provided in different ways.

The traditional way:
This is typical in traditional finance: liquidity for exchange trading is usually provided by a privileged class, the so-called Designated Market Makers. This privileged class is usually closely connected to the exchanges in the name of market-making licenses. With the licenses, they usually enjoy a series of privileges and advantages:

  1. Informational: they can see more depth in the orderbook (while most people usually can only see bid1 and ask1 unless paying more);
  2. Technological: they can run their trading programs on a server with extremely low latency (the so-called co-location) to front-run most other people;
  3. Financial: their trading costs are usually significantly lower than ordinary people’s (sometimes even negative).

Crypto centralized exchanges:
While many centralized crypto exchanges still follow the old wall street traditions, there is something new. Bitmex, for example, differentiates the parties of a transaction into two sides: a maker and a taker. While the taker pays the taker fee (e.g., 0.075%), the maker receives part of it (e.g., 0.01%) as “maker rebate”. Also, everyone can see the whole orderbook on Bitmex. Essentially, Bitmex has dropped the identity threshold and substantially democratized the market-making business. So anyone making a quote into the orderbook is part of the market-making business and thus shares its profit. So far, things have somewhat improved: the club’s door is now open to the Main Street people. However, whether you can join the party or not depends on how well you can dance. Marketing-making on Bitmex is not easy at all. In fact, it’s way beyond the ability of average Main Street people.

AMM by DeFi:
AMM has (almost) completely removed the threshold for providing liquidity to trading: you don’t have to be a skilled expert, let alone an “aristocrat”. The only skill you need to master is operating a web3 wallet, e.g., Metamask. For the first time in history, AMM has made it possible for Main Street people to participate in liquidity-providing of trading business. This is the case for Uniswap, Curve, Balancer, DODO, Sushiswap in the spot trading sector, and also the case for Deri, Perp, GMX in the derivative trading sector.

Let me summarize the requirement to provide liquidity for trading:

  1. In traditional finance, you have to be both privileged and skilled;
  2. In some crypto centralized exchanges, you don’t have to be privileged but still have to be skilled;
  3. In AMM-based decentralized exchanges, you don’t have to be privileged or skilled.

In case 1, due to the privilege and skill bars, a handful of companies have monopolized the business. This cash-printing-machine business made them colossal wealth, which further strengthened their monopoly. Essentially, they have become a class of financial aristocrats.

In case 2, even though the privilege bar is dropped, it is still largely the same bunch of people from case 1 doing the business. If you know the big players of crypto market making, you know what I am talking about. After all, that is what they have been doing for decades. Even without the privilege threshold, their skill advantage still puts them on a significant edge. This skill advantage is based on how to play with orderbooks. That is why orderbook is the technology adopted by the old “financial aristocrats” (a.k.a. Wall Street) to rule the financial empire on the old lands and expand it to the crypto new lands.

In case 3, usually one can participate in the liquidity-providing for whatever trading objects with a few clicks. As this procedure barely requires any expertise in market making, it really opens up the door for Main Street people.

Transaction fees generated by the USDC-ETH pool on Uniswap V3. Anybody can participate in the liquidity-providing and share these fees without market-making expertise. (Screenshot taken from as of 2022–6–25)

In short, AMM is the fintech of the people, by the people, for the people!

What about orderbooks in “DeFi”?

At the moment, the leading way of providing liquidity for trading is AMM. However, there are also “DeFi” platforms adopting the orderbook mechanism, of which dYdX is the leading example. The fact is, most of them are nothing but fake “DeFi”. Transactions on such platforms usually take place on their own dedicated server (or AWS server), only connected to blockchain networks by some “layer2 technology”. Connecting an order-matching engine running on a centralized server to Ethereum by some layer2 technology does not make it decentralized. Neither does adopting a so-called “standalone blockchain” (or app chain), as announced in dYdX’s V4 plan. While adopting a standalone blockchain might make it more decentralized since “each validator will run an in-memory orderbook”, it does not change the fact that the transactions (order-matching) take place on off-chain servers. The validators are there only to make sure the transactions are legitimate. Such platforms lack almost every advantage that a DeFi project has: composability, transparency, and interactability.

And most importantly, such platforms are usually ruled by the same bunch of traders from Wall Street doing their old business. In other words, such platforms are nothing but the expansions of the old financial aristocrats (aka Wall Street). Just look at who is making markets for dYdX, and you will see it. And it will be exactly the same situation after dYdX migrates to V4.

Please note this does not mean such a semi-decentralized approach by projects like dYdX is useless. Platforms with this approach could be as great as Bitmex, Binance, FTX, etc. They are just not DeFi (you don’t have to be DeFi to be great). Such platforms, together with the centralized exchanges, usually serve high-frequency trading (a typical institutional demand) much better than AMMs. However, besides lacking the typical DeFi advantages, they just cannot do what a real DeFi solution does — open up the market-making club door for Main Street people to participate and share the profits. Due to its large amount of trading volume, dYdX generates huge profits for its market makers every day. But this has nothing to do with you or me outside that aristocrat club. A great example of contrast with dYdX is Deri Protocol adopting the AMM trading paradigm: anybody can participate in the liquidity-providing for derivative trading and share the profits, without mastering the sophisticated derivative skills.

The LP net value growth of Deri Protocol‘s Main pool since Jan 2022 displays how anybody can share the profits of derivative market-making. (Screenshot taken from as of 2022–6–25)

And that is why DeFi must choose AMM rather than orderbook as the market-making paradigm.

About Deri Protocol

Deri, your option, your future!

Deri is the DeFi way to trade derivatives: to hedge, to speculate, to arbitrage, all on chain. With Deri Protocol, trades are executed under AMM paradigm and positions are tokenized as NFTs, highly composable with other DeFi projects. Having provided an on-chain mechanism to exchange risk exposures precisely and capital-efficiently, Deri Protocol has minted one of the most important blocks of the DeFi infrastructure.

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Deri Protocol = (Perpetual Futures + Everlasting Options) x Decentralized.

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Deri Protocol

Deri Protocol = (Perpetual Futures + Everlasting Options) x Decentralized.