DeFi and the orderbook wars
Cycles and trends
The bear market is here; projects that solve non-existing problems and teams with bad budget management will be forced out of the market. Those are challenging times for crypto and old-school established industries, but that’s how things are. Life and death, water, and seasons are cycles that repeat over and over. That’s how the universe works; markets are no exception. Humans learn from those experiences and adapt to harness the knowledge to build better and more robust systems. In the past few months, we saw the necessity to improve the experience in DeFi for both institutional and other experienced traders. The trend is pointing in one clear direction: orderbooks.
What’s holding DeFi back for the next cycle?
Yield farming or liquidity mining shows that finance can exist and function on-chain. The AMM era started because we needed a substitution for centralized exchanges - a new way where we can trade tokens without going through the KYC process, without worrying about the custody risks presented when holding tokens on exchanges like Binance, Gemini, FTX, etc.
AMM model was the best option at the time because the innovation was mainly coming from the Ethereum ecosystem; the design was compatible and highly user-friendly. And that’s how AMMs caught on fire, other chains followed the movement, and the DeFi boom started. The major drawdown is that the liquidity for AMMs is provided mainly because of the liquidity mining incentives. Those inflationary rewards are under sell pressure during bear markets, and the model slowly wears off.
AMMs are facing their first genuine downturn, and the reality is that a lot of AMMs will get flushed out if they are not actively innovating. On the other side, regulations of centralized exchanges are already underway, and this could be the perfect time for DeFi orderbooks to take over a fair market share.
Orderbook wars
Crypto is the answer to the centralization of power, especially in finance. That’s why we need all the requirements and tools to accommodate the legacy financial system on the blockchain. Without this, crypto is still an underdeveloped technology not taken too seriously by big institutions. In today’s age, almost all the trades are executed on orderbooks; they are the key to getting closer to mainstream adoption, and that’s where crypto is headed.
Decentralized orderbooks require high throughput and low execution cost to function appropriately and rival the capabilities of centralized exchanges. In other words, transactions must be cheap and fast to execute. Ethereum layer 2 solutions and other prominent layer 1s offer the right environment to build orderbooks.
Last year’s orderbook DEXs started popping around all ecosystems offering spot and perpetual markets. However, the timing was off because all the yield farming protocols flooded the market; everyone provided liquidity. During a bear market, things could shift to a more traditional way of earning. Let’s cover the most prominent existing and coming orderbooks.
Ethereum L2s
dYdX
Ethereum, with its speed and gas cost problems, cannot offer the playground for an orderbook DEX, but its layer two scaling solutions are already in use. dYdX is the most known derivative exchange; it sometimes processes more transactions than the most established exchange, Coinbase. dYdX operates through smart contracts on the Ethereum blockchain and a Starkware Layer 2 scaling protocol.
They recently announced that the protocol’s next version would move to Cosmos as an independent and sovereign app chain. They are planning on using an off-chain orderbook for the new version, massively improved throughput (an increase of 100x), and no trading fees while increasing decentralization.
A serious player like dYdX moving from Ethereum to Cosmos shows how much a dedicated application-specific chain means to a successful project with high volumes.
Cosmos
Injective protocol
Injective was the first orderbook-based decentralized exchange in the Cosmos ecosystem with Ethereum compatibility. Injective features a custom-made CLOB (central limit orderbook) and supports cross-chain trading of spot crypto, perpetuals, futures, synthetics, and various assets across distinct blockchains such as Ethereum, BSC, Cosmos, and Polkadot. The short block time and instant finality granted by Tendermint core allow the protocol to handle high transaction demand while keeping the chain secure and trustless.
The INJ protocol is EVM compatible, so users can use the MetaMask wallet to interact with the protocol besides keplr and Ledger.
Sei Network
Sei is an upcoming Layer 1 blockchain, purpose-built for orderbook DeFi. The chain’s primary focus is reliability, security, and high throughput. Sei’s on-chain CLOB (central limit orderbook) and matching engine provide deep liquidity and price-time-priority matching for traders and apps. Like Injective, we can expect Sei to offer cross-chain trading of synthetic and spot assets. Since Sei is built on the Cosmos SDK, we can confidently expect fast, if not record-fast block times. Both Injective and Sei are sovereign Layer 1s focused on bringing DeFi to a new level, meaning that no other dApps will use the same block space while retaining interoperability using IBC. This is the most reliable way to build functioning and world-class blockchains.
Some projects like Vortex and Pharaoh have already announced the intention to build on Sei, so this project seems worthy of following closely.
Polkadot
Polkadex
Polkadex orderbook is a parachain on the Polkadot network. It aims to become the non-custodial, peer-to-peer trading platform for the Polkadot ecosystem. With high security, Polkadex will provide extremely low latency- estimated at 20 milliseconds and no gas fees, making the platform suitable for high-frequency trading. What’s interesting is the fact that Polkadex is the first to use the Substrate abstraction layer for SGX Intel technology, called SubstraTEE which acts as a layer 2 scaling solution to make fee-less transactions possible in combination with IPFS or Interplanetary File System to maintain a snapshot of the latest state of balance transfers.
Polkadex will use the XCM protocol as the cross-chain communication layer to send and receive tokens. XCM is similar to the Cosmos Inter-Blockchain communication protocol (IBC). They fall under standardized bridges with higher security than other cross-chain bridges. The beauty is that chains can enable both XCM and IBC to become interoperable, bridging both ecosystems.
Solana
Serum is a fully on-chain orderbook DEX running on the Solana blockchain, offering incredible speed for DeFi tasks in a permissionless manner. Currently, there are 30 apps composing the ecosystem using the on-chain CLOB. Like the other protocols, liquidity is shared across the ecosystem (serum), and the Solana blockchain provides security. The security part has a positive and a negative side; high security is an excellent benefit when a lot of economic value is locked in a protocol. On the other side, outages caused by other dApps on the same blockchain can negatively impact the protocol’s reputation.
Serum, at its peak in March 2022, was processing around $10b monthly, a long way to go to flip AMMs but an excellent start for an orderbook that is not quite as mainstream.
Conclusion
Even though DeFi started in 2015 with Maker DAO and the stablecoin DAI, no significant traction was obtained until 2019/2020. DeFi offers a distinctive way of trading more transparently and efficiently than traditional markets. Global GDP is around $95t, nothing compared to the derivatives market, which some estimate to be approximately ten times bigger.
As blockchain technology matures and regulations boost institutions’ confidence, we could see a natural movement towards decentralized technology. Censorship-resistant and efficient systems will prevail over the long run. After what we’ve seen in the last few months, DeFi will be a necessity and not just a fancy tool. Like the internet disrupted the way we are doing business, the same effect will be applied by blockchain technology, crushing the competition that will not adapt.
The projects above are not the only ones building such solutions. Thorchain and Kujira are also part of the orderbook wars. Both projects are built using the Cosmos technology stack, which is a sign of strength in the sovereign application-specific blockchain narrative.
The bear market is the best time to silently build-out projects and ideas that will drive us into the next bull market.
