Let’s face it: the future of trading is not on centralized exchanges like Binance and Coinbase. If you have not really been following, there have been quite a few debacles over the last few months. Meanwhile, decentralized exchanges (DEXs) have proven to be a reliable and resilient part of the crypto ecosystem.
With all transactions recorded on a global & immutable ledger, DEXs need to adhere to a level of security and transparency that is much higher than centralized entities do. There is no room for lying, cheating, hiding of customer funds, or any of the other shady stuff done by the centralized entities. That is why one of my predictions for 2023 is that Uniswap surpasses Coinbase in terms of volume.
It is important to note, however, that centralized exchanges still offer more complex trading options that your average AMM DEX. So if we genuinely want to steal more volume from our centralized counterparts, we will need to have feature parity with exchanges like Binance. That is what we will cover in this piece. More specifically, we are going to have a look and compare oracle-based DEXs (GMX type) and order-book-based DEXs (dYdX type).
ARTICLE OUTLINE
Definitions (feel free to skip if already familiar)
DEX
Oracle
Order-book
Spot, futures, perps, derivatives, margin trading & leverage
Oracle-based DEXs
GMX
Order-book based DEXs
dydx
Future - what is the most sustaining approach?
DEFINITIONS
Before we get ahead of ourselves, let me introduce some concepts that are important if you would like to understand this article. I do not want to waste your time, so if you are crypto native, you can skip to part two of the article!
First of all, what is a DEX?
A decentralized exchange is a platform that allows users to buy and sell cryptocurrencies and other digital assets without the need for intermediaries. This means that they do not rely on a central server or organization to facilitate trades. Instead, DEXs use smart contracts to execute trades and transfer assets between users.
One of the main benefits of using a DEX is that it allows users to trade digital assets in a secure and transparent manner. Because all transactions are recorded on the blockchain, DEXs provide a high level of security and transparency that is not possible with centralized exchanges.
Additionally, DEXs do not hold users' funds, which means that users are in control of their assets at all times and are not vulnerable to the same types of risks that centralized exchanges can pose.
OK, you mentioned Oracle somewhere, what is that?
An oracle is a third-party entity that provides reliable and accurate data to decentralized systems. Oracles are used to verify the terms of a trade or to provide data that is needed to execute a smart contract. Basically, Oracles allow you to take external data (non-blockchain or a different blockchain), verify the validity of that data & import it into your own ecosystem.
For example, an oracle might be used to provide data about the current price of a particular asset, which could be used to execute a trade on a decentralized exchange. Oracles can be trusted because they are typically secured by multiple layers of protection, such as cryptographic signatures and reputation systems.
What about order-books?
An order book is a list of buy and sell orders for a particular asset, with the orders organized by price. Order books are used by exchanges to facilitate trades between buyers and sellers.
When a user places an order to buy or sell an asset, it is added to the order book. When a matching order is found, the trade is executed and the orders are removed from the book. Order books can provide a high degree of transparency, as they allow users to see the full range of available prices and to make informed trading decisions.
Some general market definitions:
Spot trading refers to the buying and selling of financial instruments or assets for immediate delivery.
Futures contracts are agreements to buy or sell an asset at a predetermined price at a specified time in the future.
Perpetual contracts, also known as perps, are a special type of futures contract that do not have an expiry date and can be held for as long as the trader wishes.
Derivative trading involves buying and selling financial instruments whose value is derived from an underlying asset, such as a currency, commodity, or index. Derivatives can be used for hedging, speculation, or to gain exposure to an underlying asset without actually owning it.
Margin trading refers to the practice of borrowing funds from a broker to trade assets, with the expectation that the value of the assets will increase.
Leverage refers to the use of borrowed funds to increase the potential return of an investment. In the context of margin trading, leverage allows traders to enter larger positions than they would be able to with their own capital alone.
Oracle-Based DEXs
As the name says it, these exchanges rely on external data sources, or oracles, to determine the price at which trades will be executed. You could argue that oracle-based DEXs can be more efficient than their order-book-based counterparts because they have lower liquidity needs, as they do not rely on matching buy and sell orders. This means that oracle-based DEXs do not need to maintain a large volume of orders in the order book to facilitate trades, as is the case with order book-based DEXs.
However, relying on external data sources can make them slower than order book-based DEXs and may also involve higher fees or other costs. Additionally, oracle-based DEXs may be more susceptible to manipulation or other forms of interference from the oracles providing the data. You could also argue that it is easier to copy an oracle-based DEX because of the lower liquidity requirements that are needed to spin up one. You can just fork one: you copy the code, create a new user interface and attract users. Low liquidity requirements = easy to copy!
The most well-known project in this category is GMX:
GMX is a spot and derivative trading protocol that has gained a lot of hype and popularity over the last few months. One of the main reasons for this is due to the way it distributes actual revenue to token holders without diluting them by inflating their own token. Revenue (from transaction fees) is mostly distributed in ETH or AVAX.
For more in-depth info, check out:
Order-Book-Based DEXs
Order-book-based DEXs, on the other hand, require the creation of an order book and the matching of buy and sell orders. If there is not enough liquidity, it can be hard to match buyers and sellers, which can result in slow trade execution.
However, order book-based DEXs offer a greater degree of transparency and are more resistant to manipulation (no oracle dependency). They may also be more attractive to more experienced traders, as they allow traders to see the full list of buy and sell orders for an asset allowing them to choose the best price for their trade.
The most well-known project in this category is dYdX:
dYdX is a protocol that allows users to trade cryptocurrency derivatives. Users can place orders to buy or sell assets at a specific price. These orders are then matched with other orders to execute trades. dYdX also offers margin trading, which allows users to borrow funds to trade with leverage. It has recently announced that it will be spinning its own app-chain on Cosmos.
For more info, you can check out:
The future
Okay, so which type of exchange makes the most sense?
If we think about the long-term future of the crypto industry, I would say both types of exchanges are likely to find their own niche and have a place in the industry.
However, if we are thinking about which type of DEX is more likely to achieve mainstream adoption and attract a lot of volume and activity, then order-book-based DEXs seem like they have a higher chance of pulling it off.
But Fekri, didn’t GMX reach its ATH during a bear market? It’s revenue has been increasing consistently and so has its usage.
Well, that is true. However, there is a limit on how big oracle-based DEXs can grow because of the way they are built. On an oracle-based DEX the fees are higher and the execution is not as good as it should be. On GMX for instance, it is easy to pay 0.1-0.2% per trade, while you would only pay 0.02-0.03% in other places.
Now why is this? Very simply because these oracle-based DEXs are taking on risk. Remember that oracle-based DEXs get their prices from oracles - there is no organic price discovery. Therefore, every time a trade is executed, they need to make sure the protocol doesn’t get blown up and gets bad debt because of a price change. That is why you have to pay a higher fee: they slow down your transactions so they can get the price from the oracle first. Which means you are getting suboptimal execution.
And because of these reasons, big professional traders & institutions stay away, simply because it can be hard making money if you are trading a lot and are paying high fees every time you execute a trade. Sophisticated traders want to get good execution and want to be able to finetune and optimize how much they pay for fees and execution. And at the end of the day, most volume on exchanges is typically generated by sophisticated traders. And so if you want to attract a lot of volume, you need to attract the professionals, and if you don’t, there is only so much you can grow.
That is why order-book-based DEXs seem like they are a much better fit. Here, price discovery happens organically and without interference. This means that traders can seamlessly and efficiently agree on the current price of an asset without a lot of friction or high fees. They can optimize for execution and price. And the fees are also much lower because the protocol itself is not taking any risk here, so it only needs to charge a low technology fee to keep things running. Obviously, they are more difficult to get up and running because of the high liquidity requirements. But I am pretty confident that some of the (remaining) big players and market makers in the crypto industry are more than willing to help with that.
Merci les amis
Thank you for reading until the end. The TLDR is: is price discovery happening organically or is a third-party oracle is being used to provide data about the prices of assets. Each design model comes with its own set of pro’s and con’s.
Some users may be willing to pay higher fees and accept worse execution on oracle-based DEXs in exchange for a more user-friendly interface, but most volume on exchanges is typically generated by sophisticated traders who prioritize optimizing fees and execution. That is why it seems likely that order-book-based DEXs have a higher chance at attracting most of the volume out there.