Liquidity Pools

The Hybrid Liquidity Engine - Best of AMM Pools and Orderbooks

Introduction

Demex uses a Hybrid Liquidity Engine that provide traders with the benefits of both Automated Market Makers (AMMs) and Central Limit Order Books (CLOBs). This is done by combining the liquidity provided by the Liquidity Pools with the order matching functionality of an order book.

Markets on Demex therefore have tighter bid-ask spreads, better order execution, and quicker price discovery.

The Hybrid Liquidity Engine also gives rise to multiple benefits such as:

• Trading of markets without the need for a counterparty / external market makers;

• Enables traders to enhance their liquidity by leveraging liquidity pools, where anyone can contribute liquidity to the pools. The hybrid liquidity engine then uses the liquidity from the AMM and spreads it on both sides of the orderbook.

Automated Market Maker (AMM)

AMMs serve as high volume market makers that provide liquidity for multiple trading venues at a time while acting as intermediaries to mitigate the liquidity issue. This enables trades that would otherwise not have been executed in those markets

When a limit order is executed, the AMM engine uses the liquidity from the liquidity pool/vault to fill the order. If the liquidity in the pool/vault is insufficient to fill the order, the remaining portion of the order is placed in the order book and matched with other orders in the future.

Central Limit Order Book (CLOB)

Instead of relying solely on the AMM to match orders, the hybrid system also has an order book that allows traders to place limit orders at specific prices. These limit orders are stored in the order book until they are matched with a corresponding buy or sell order from another trader.

What do liquidity pools solve?

For any sort of trading to happen, buyers and sellers have to converge on the price of an asset or contract.

However, this requires a first mover (i.e. the maker) to place his trade intent (e.g. by placing an order on the orderbook). Other traders can then review this quote and either accept it by taking the order (i.e. the taker), or place a counter quote at a different price (thereby becoming a maker on the order side of the book). When this happens iteratively, a liquid order book is eventually formed, and the marketplace has now converged on a good indicative "fair" price for future takers.

As you might imagine, this requires multiple parties willing to wait for some indeterminate period of time for the trade to occur. In some markets or venues, there may simply not be sufficient traders or liquidity for that to ever happen.

A traditional market maker solves this problem by committing to always be active in a certain market to act as buy or sell quotes for other takers. Centralized cryptocurrency exchanges (CEXs) also partner with market-makers to provide this liquidity.

In general, market makers are incentivized to do so by profiting off the difference between their quoted bid and ask prices (i.e. the spread). To perform this service though, market makers need sophisticated knowledge of trading, require programming resources, among other things.

In a decentralized exchange (DEX) like Demex, there is a further innovation on the concept of market makers that makes the game fair and permissionless!

In DEXs like Demex, any user can in fact become a market maker by simply providing liquidity.

For spot markets, users may provide the two tokens belonging to both side of a spot market to a common pool (known as a "liquidity pool"). This combined liquidity is then managed by an automated market maker (or "AMM"). The AMM typically acts in a path independent way such that it is resistant to manipulation, and will not lose money except for a transient change in market prices.

For perp markets, users provide stablecoins to a common pool (known as a "perp pool"). This liquidity is then managed by an AMM which regularly quotes bids and asks near the oracle price based on the configuration of the perp pool in a way that is resistant to manipulation.