Liquidity Pool vs Order book
Updated: Mar 28
Thanks to the significant growth of decentralized finance (DeFi) in recent years, many DEXs have been created to fix problems that have always characterized centralized exchanges (CEXs), such as hacks and malicious operations, lack of privacy, deposit limits, intermediary issues, trust, and high fee costs.
This article focuses on the differences between order books and automated market makers and whether it is worth having a market of only liquidity pools or should not leave out the order book model.
What is a liquidity pool and how does it work?
Liquidity pools support the DeFi ecosystem and are essential to automated market makers (AMM). A liquidity pool is a set of funds locked in a smart contract. These pools facilitate decentralized trading and lending and are the pillar of many decentralized exchanges (DEX).
Users that take part in Liquidity pools, also known as liquidity providers (LPs), add an equal value of a pair of tokens in a pool to create a market. In exchange for the funds provided, they receive the trading fees of transactions (also known as LP tokens) carried out in the pool in proportion to the amount of liquidity they have supplied. A fractional fee is proportionally distributed amongst the LP token holders when a pool facilitates a trade.
Here is a video on how liquidity pools work
What is the point of a liquidity pool?
As we said above, when you execute a transaction on an AMM, you do not have a counterparty; in other words, to allow buyers to buy and sellers to sell, you need only enough liquidity in the pool. Assets are entirely managed by an algorithm that determines what happens in the pool and defines the price according to the transactions carried out. One significant difference with an order book model is the direct interaction with the smart contract.
What is an order book?
To fully understand the functioning of liquidity pools, it is important to understand the concept of the order book. An order book is a collection of open orders for a given market, using a system that matches orders called “matching engine”. It matches buyers and sellers, allowing participants to place orders, their best bid or ask prices, on assets and wait for somebody else to come along and fill their orders. Order books and matching engines are the cornerstones of centralized exchanges.
Trading in decentralized finance is different from using a CEX. The transactions are on-chain, no one holds the funds and interactions with the order book require high fees. This makes trading and the work of liquidity providers quite expensive.
It should also be remembered that most crypto assets are created in the form of ERC-20 and then on Ethereum. You can not exchange them on other networks unless you use cross-chain platforms.
A good decentralized exchange that works with an on-chain order book is Binance DEX.
The risk of having a liquidity pool market without an order book
The automated market makers solve one of the most significant issues of DEXs, but at the same time, the order book-based are working hard to improve the liquidity. Currently, the best approach is probably developing DEXs based on an AMM because many solutions have emerged that promise to solve the issue of impermanent loss.
But suppose we broaden the horizons and see the promising future of hybrid finance (HyFi). In that case, the best solution is probably decentralized hybrid exchanges (Hybrid DEX) that incorporate both AMM and order books.
What do you think about it, are you a fan of liquidity pools?