Decentralized Exchanges (DEX), in order to provide a market price, usually rely on one of the following systems: Order Book or Automated Market Maker (AMM).
So, which one is better? Our team has been researching the different systems for a few months and came to the following conclusion: it depends on the kind of tokens you want to serve on the exchange.
The Order Book model works best when the exchange offers trading pairs that have high liquidity (e.g. BTC/ETH, ADA/USDT, BTC/BUSD). The majority of centralized exchanges use Order Books, including the biggest ones such as Binance, Bittrex or Coinbase. IDEX, a decentralize exchange for ERC-20 tokens, uses the order book model.
However, if a market is illiquid, order books don’t work that well. You can make an order, but finding a match for it won’t be as easy, and you’ll have to wait a long time. This often means you will not be able to escape volatility and large spreads occurring in these situations.
Switcheo is an example of an order book style DEX. After 4 years of launching it has only 7 BTC in daily volume. It is a bad experience for users who want to trade their assets. Because of the low liquidity users have to wait a long time, sometimes weeks, for an order to be completed. That is if the order can be completed at all. Many times orders stay just open without having been able to find a counterparty to trade with.
An Automated Market Maker model (this is the type that Uniswap uses), on the other hand, suits better if the exchange offers mainly pairs with low liquidity. The main advantage of an AMM system is that there will always be liquidity for otherwise illiquid markets — at least while there are enough people to invest in a liquidity pool.
However, what if there isn’t enough liquidity around the desired price to fill a large market order? There could be a big difference between the price that you expect your order to fill and the price that it fills at. This difference is called slippage. This, together with impermanent loss are the main disadvantages of an AMM system.
Projects that issue their own token come to a DEX to find liquidity. Although a AMM system allows them to create a new pair (Bobtoken/ADA), it also means they need to have a enough capital in order to create a liquidity pool that is liqwid enough so that they don’t end up with a high slippage if a large order is executed.
So, the bigger the collateral, the more liquid the pool becomes and lower slippage happens when bigger orders are executed. This is a problem, because many new projects that will launch their own native tokenon Cardano will be rather small and therefore won’t have a lot of capital upfront.
Also, AMM markets act as uninformed, as the price is set by a pricing algorithm rather than an order book. Read more about it on this article.
So, is there a way to get the best of the two worlds? Could we have a system that:
- Allows anyone to become a market maker by either starting a liquidity pool or participating in an existing one.
- Minimizes slippage
- Minimizes the risk of impermanent loss
- Provides more price transparency
- Allows token issuers to create a new pair without the need of big a amount of capital to serve as collateral.
This is what will make Cardax different.