The FTX collapse injected doubt into the very concept of centralized platforms. In contrast, decentralized exchanges offer both transparency and self-custody. But how can DEXs bridge the liquidity gap that CEXs offer?
Vertex Protocol, a decentralized trading platform, aims to solve this problem through a number of innovative solutions, such as cross-margining, near-instant order executions, no MEV, and vertically integrated products. To understand what that means, we first need to understand why decentralized exchanges haven’t gained as much traction as CEXs.
Centralized Exchanges (CEXs) = Deep Liquidity
FTX crash in November erased almost a quarter of the value of the global crypto market. It compounded the contagion triggered by the prior failures of Terra, Three Arrows Capital, and Celsius. Soon enough, more dominoes toppled — BlockFi and Genesis Trading.
All of them have one thing in common — a centralized governing structure that offers double-digit earn yields to attract users, reckless trades to keep afloat, and mismanagement of customer deposits.
There was a time when the crypto space was envisioned as a decentralized and self-custodied system. This not only included Bitcoin as sound money, but financial services as well, known as DeFi. Both centralized exchanges and CeFi rose to the top instead.
The reason for CeFi dominance is simple: convenience and deep liquidity. The latter is defined by two factors:
Tight spreads — minimum difference between a bid and an ask when trading.
Low slippage — minimum difference between the expected and settled trade price.
Centralized exchanges (CEXs) offer both because they don’t rely on users to supply the liquidity across numerous fragmented liquidity pools.
In contrast, decentralized exchanges (DEXs) rely on smart contracts to lock in users deposits — liquidity pools. Traders then tap into their liquidity for various token pairs, such as wBTC/USDC or ETH/USDT, without the need to match existing orders.
In other words, DEXs rely on the popularity of their platforms to attract more liquidity providers for efficient trading. Additionally, on-chain transactions are as fast as the blockchain network allows them to be. Another problem that doesn’t exist with CEXs.
Vertex protocol comes into play to resolve this imbalance between CEXs and DEXs. But how can this be accomplished?
Key Advantage of CEXs Explained
Like Uniswap, Vertex is a decentralized exchange protocol. However, it uses a hybrid order book automated market maker (AMM). The job of every AMM algorithm, from Uniswap to PancakeSwap, is to track and pool the liquidity coming from separate liquidity pools supplied by users. Then, the AMM algorithm delivers the available price for each token pair trade, depending on the status of liquidity pools.
In other words, decentralized exchanges allow users to trade between each other, on a peer-to-peer basis, but through the AMM algorithm. This is quite different from traditional order books:
Trades are listed on each side of the ask/bid wall.
Sell limit orders are represented as red, while buy limit orders are green.
Contrasted and visualized, these ask/sell orders measure the volume on each side of the supply/demand, otherwise known as market depth.
The distinct advantage of a traditional order book is the very creation of a limit order in the first place. This is the price a trader sets to either commit to an ask (buy) or a bid (sell). So, centralized exchanges can execute these orders automatically when the order reaches the specified price.
Additionally, large CEXs handling enormous volumes have enough liquidity to execute these trades instantly. This is critical to avoid slippage. Traders can see the order book volume on both sides of the trading equation, which hints at the direction of the asset’s price.
Bridging the DEX Liquidity/Execution Gap
Now that we understand the difference between order books and AMMs, it is easier to understand the Vertex protocol. As mentioned, it uses a hybrid orderbook-AMM. To become as efficient as a CEX’s order book, a DEX would have to offer the following:
Low latency – placing and executing trades in fractions of a second, as well as viewing the results. Decentralized blockchains inherently introduce lag due to the need for all transaction blocks to go through a consensus algorithm across the network’s nodes.
Scalability – the main obstacle to mainstream adoption, which is why Ethereum heavily relies on Layer 2 scalability solutions such as Arbitrum or Polygon. This is in addition to volatile gas fees for executing transactions.
MEV – miner extractable value. Taking advantage of smart contract inefficiencies, such as order of transactions in a block, miners are incentivized to find extra profits. Typically run by bot scripts, it is considered a malicious but unavoidable behavior.
Front-running – By the same token, both miners and validators, in either Proof of Work or Proof of Stake networks respectively, can use knowledge of upcoming trades to execute their own trades first, ahead of the original ones.
Vertex aims to solve these vulnerabilities with a hybrid approach, by using on-chain AMM with an off-chain orderbook. This is a two-layered approach in which the offchain orderbook, dubbed “sequencer,” is running on top of the AMM algorithm.
Specifically, Vertex AMM matching engine is running on Arbitrum, as fully on-chain, which means that all trade settlements are also executed on-chain. This is Vertex’s default state. In turn, Vertex Sequencer (EDGE) stores non-executed orders, later to be relayed to Arbitrum for execution.
Connecting to EDGE, Vertex facilitates Application Programming Interface (API) to plug Vertex’s protocol into external exchanges to execute trades, in addition to checking asset prices, placing orders, and checking account balances.
This API is the hybrid aspect of Vertex, enabling lightning-fast performance, at 10–30 ms, which is comparable to the fastest CEXs like Binance. Visualized, Vertex’s on-chain AMM with the off-chain EDGE sequencer for order matching looks like this.
In practice, the end-user links with Vertex as with any other dApp, like Uniswap or Curve. Its sequencer then handles the aforementioned issues of latency, scalability and MEV/front-running.
For a specific trade, Vertex hybrid orderbook AMM delivers minimum slippage and fast execution, all the while facilitating the trustless nature of DeFi.
At the end of the Vertex line, the ultimate goal is to create a distributed sequencer layer that can serve as a liquidity layer for DeFi protocols across all EVM-compatible chains.
How Would Vertex Have Prevented the FTX Fiasco?
Among traders, FTX was known for its line of derivative products: futures contracts, options and, of course, leveraged tokens. Due to the fact that traders could amplify their market positions with leverage, they could also amplify both their gains and losses.
Likewise, it bears keeping in mind that margin trading is a form of leveraged trading, but leveraged trading is not limited to just margin trading. After all, leveraged trading includes any trading strategy that uses borrowed capital, which could also come in the form of options or futures.
Suffice to say, maintaining the risk of such complex strategies is extremely important. Vertex facilitates it with the use of cross-margined trading accounts. This means that traders can have a single portfolio to margin across perps, spot, and other money market ventures on Vertex. FTX gained popularity with just such portfolio margins.
With a self-custodial wallet access and underlying decentralized layers — Arbitrum and Ethereum — Vertex ensures the ownership of assets. There is nobody that can, at a press of a button, funnel customer funds to a hedge fund like Alameda Research for gambling purposes.
For that to happen, Vertex sequencer, as the only off-chain cog, would have to be dishonest. But the sequencer cannot take custody over users’ funds, nor can it forge transactions. Consequently, in the worst-case scenario, users’ trades simply fall back to Arbitrum-hosted smart contracts, leaving the funds intact.
Note: This explainer was sponsored by Vertex
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.