The Maturity of DeFi Requires a Shift from Automated Market Makers to Central Limit Order Books

Effective trading mechanisms are crucial to DeFi, as without them, the entire ecosystem would struggle to operate efficiently and attract users, ultimately limiting its growth and impact. Currently, DeFi primarily relies on Automated Market Makers (AMMs), while Central Limit Order Books (CLOBs) are emerging as an alternative.

Automated Market Makers (AMMs) revolutionized DeFi asset trading by enabling straightforward swaps without the need for traditional order books. Their user-friendly approach has made AMMs the dominant trading method in DeFi, allowing users to trade directly from their wallets without needing to navigate complex order types. However, a new mechanism is gaining traction across DeFi: Central Limit Order Books (CLOBs).

While CLOBs have long been a staple in traditional finance, their adoption in DeFi is still in its early stages. CLOBs require high transaction throughput and low latency to match and execute orders efficiently, which poses a challenge for most blockchains—especially Ethereum—before the advent of rollups and sharding. As blockchain scalability improves, L2 solutions like Fuel are making CLOBs a viable option, by allowing developers to build smart contracts that require high performance virtual machines to be efficient.

The emergence of DeFi based CLOBS signals that the DeFi sector is maturing and positioning itself for a wave of institutional engagement. Additionally, the integration of both AMMs and CLOBs can help create a robust DeFi ecosystem that accommodates a diverse user base, leveraging the strengths of each to meet varying trading needs.

How do Automated Market Makers (AMMs) work?

AMMs use an algorithm to price assets based on the constant product formula and its derivatives, the most popular being, x*y=k. AMMs enable traders to exchange assets directly from liquidity pools without requiring a counterparty, unlike traditional order books. Instead, on AMMs traders trade against the liquidity of passive liquidity providers who earn fees for providing liquidity to the protocol.

This approach has been revolutionary in DeFi, allowing anyone to provide liquidity and participate in trading without needing to be a professional trader or quant.

How do Central Limit Order Books (CLOBs) work?

CLOBs facilitate efficient and transparent trading by matching buy and sell orders based on price and time priority. Traders submit various types of orders, including market, limit, and stop orders. CLOBs continuously update to reflect current market conditions, showing outstanding buy and sell orders and providing insights into market depth.

For instance, if a trader wants to buy 1 Bitcoin at $60,000, they submit  a limit order to  the CLOB. If a seller is willing to sell 1 Bitcoin at $60,000, the two orders can be  matched, and the trade is executed. If no seller is available at that price, the order remains in the book until a matching seller is found.

The  speed and precision of CLOBs make them ideal for high-frequency and algorithmic trading, attracting professional traders and institutional investors by offering greater flexibility and control.

Key Differences Between CLOBs and AMMs

Why Will CLOBs Play an Important Role in the Next Phase of DeFi?

The next wave of DeFi growth is expected to be driven by increasing institutional investment and interest. According to Northern Trust, financial institutions are preparing for significant adoption of digital assets and tokenization, which is expected to accelerate institutional DeFi over the next few years. Additionally, industry experts predict substantial growth in DeFi due to the tokenization of real-world assets, further attracting institutional investors. Binance Research notes that the total value locked (TVL) in DeFi has surged by 75.1% year-to-date, reaching $94.9 billion, with significant capital inflows. It also highlights that yield-bearing assets saw a 148.6% increase, now making up $9.1 billion of the TVL. This influx of capital has benefited nearly every DeFi sector, making previously inaccessible financial primitives available on chain.

To accommodate this shift, DeFi must evolve beyond the limitations of AMMs, which are well-suited for everyday users, and develop infrastructure that meets the demands of more sophisticated traders. This is where CLOBs have the potential to become a game-changer for DeFi, offering advanced trading capabilities, superior price discovery, and improved capital efficiency to support the needs of institutional participants.