Decentralized Order Book
A decentralized order book is a trading mechanism where buy and sell orders are matched through a distributed network of nodes.
What Is a Decentralized Order Book?
A decentralized
order book is a trading mechanism where buy and sell orders are matched through a distributed network of
nodes, rather than being
centralized in a single location or controlled by a single entity. In a decentralized order book, users can submit orders and execute trades without the need for intermediaries or central authorities, which helps users achieve the prices they want more closely and improve transparency.
How Is This Different From Centralized Order Books?
In contrast to decentralized order books, centralized order books are managed by a single entity that controls the platform and the matching of buy and sell orders. The centralized approach relies on intermediaries such as
centralized exchanges, brokers, market makers and custodians to facilitate trades, which can lead to higher fees and reduced transparency.
Benefits and Disadvantages of Decentralized Order Books
Decentralized order books also eliminate the need for a central authority to oversee transactions. Additionally, the decentralized nature of the order book ensures that it is resistant to downtime and hacking, as the platform is distributed across multiple nodes and serves as an optimum environment for effective price discovery.
However, this decentralization comes with its own set of disadvantages and technological challenges as a consequence of the blockchain trilemma. So while order books on DEXs provide a resilient, trustless and more private solution without a single (central) point of failure, they have also been technologically unwieldy. They are less scalable and slower as transactions must be verified by multiple nodes on the network. This verification process can require significant computational resources, causing network congestion at busy times.
The DEX Trading Evolution: Automated Market Makers (AMMs) to Decentralized Order Books (DOBs)
To tackle these technological problems, most DEXs have utilized
Automated Market Makers (AMMs). They provide a readily accessible, easy-to-use way to trade without the need for a counterparty.
However, their scalability can be questioned too, as they may struggle with handling large trading volumes resulting in high fees and
slippage. They are susceptible to
impermanent loss and can be less efficient in price discovery — leading to wider
bid-ask spreads and less
liquidity.
Additionally, in the traditional AMM model,
liquidity providers (LPs) supply equal amounts of two tokens to a
liquidity pool and earn trading fees from swaps that occur within that pool. The liquidity they provide is distributed across the entire price range, from zero to infinity. This is not
capital efficient as most trades occur in a narrow price band, leaving a large portion of the provided liquidity unused.
To improve this, the concept of
concentrated liquidity was introduced by
Uniswap v3. It allows LPs to specify price ranges for their liquidity. In other words, it enables LPs to set the price at which they are willing to buy or sell assets. This gives them more control over the prices at which they trade, making their liquidity more efficient. Thanks to this, LPs can earn many times more the trading fees than they did with traditional AMMs.
Concentrated liquidity in DEXs can be seen as a step in between AMMs and decentralized order books. The aim is to combine the advantages of trading on DEXs (self-custody and privacy) with trading on CEXs (low slippage, efficient pricing and fast settlements).
Ultimately, it is order book-based DEXs that can fully merge the financial advantages of the order book model and DEX innovations. However, this can only happen if the technological issues are solved and decentralized order books can provide a fast, seamless user experience.
Recently,
Uniswap v4’s whitepaper has proposed architectural changes in DEX operations that may improve speed — but such a promising solution may not be without risks.
Author: Guilhem Chaumont is the CEO and co-founder of Paris-based Flowdesk, which builds liquidity technology for digitalized financial markets. Prior to Flowdesk, he co-founded and served as CEO of X-Network, an open-source private cryptocurrency. Guilhem started his career as a trader for HSBC after obtaining degrees in engineering and international finance.