From AMM to CLOB and the Mechanics of Decentralized Exchanges

From the humble constant‑product formula to the intricate architecture of a CLOB, decentralized exchanges have come a long way. Over the last few years two core design patterns have emerged to drive these swaps: automated market makers (AMMs) and central limit order books (CLOBs). Deep price discovery, deep liquidity, and sophisticated order types are now the norm.

Automated Market Makers – The Basics

The most common formula is the constant‑product rule, which maintains the product of the reserves in an AMM pool. In this section we outline the core concepts behind AMMs and explain how they differ from traditional order‑book models.

Liquidity provision

• Anyone can become a liquidity provider (LP) by depositing tokens into an AMM pool. Liquidity providers earn a portion of the trading fees, but they also face certain risks, such as price impact and impermanent loss.
• Impermanent loss: As the price of the tokens in the pool changes, the value of the LP’s stake can fall relative to simply holding the tokens. Understanding impermanent loss (impermanent loss) is crucial for anyone looking to add liquidity.

Limitations of AMMs

While AMMs have democratized liquidity, they come with their own set of challenges. This section discusses each limitation in detail.

Impermanent loss

• The risk of impermanent loss is one of the most cited concerns. When the relative price of the two assets in a pool diverges, the LP may end up with a less valuable basket of tokens than if they had simply held them.

Concentrated liquidity

• A key difference between AMMs and CLOBs is the ability to concentrate liquidity at certain price ranges. By focusing depth near the current market price, traders can execute large orders with less slippage.

Price impact

• While CLOBs can offer more precise pricing for large orders, AMMs typically exhibit a higher price impact for large trades. However, with newer designs such as concentrated liquidity and range orders, AMMs are becoming more competitive.

Impermanent loss (again)

• The concept of impermanent loss is especially relevant for AMMs that use a constant‑product invariant. By providing liquidity to a pool that is constantly re‑balanced, LPs face a higher risk of loss if the market price moves away from the current reserve ratio.

Central Limit Order Books – A Classic Approach

A CLOB is the heart of traditional exchanges, providing deep liquidity and a familiar trading interface. The main advantage of a CLOB is that it offers a real‑time order book that allows traders to see the best available prices for a given asset pair. The liquidity that an order book provides is far greater than that of an AMM. In addition, a CLOB can provide real‑time price information for a given asset pair, and can be used for a variety of different use cases, from basic spot trading to margin trading and derivative trading. In this section we examine the pros and cons of CLOBs and explain why they are a more suitable model for traders who need to trade at a very high frequency or with large volumes.

Price discovery

• CLOBs enable sophisticated price discovery, allowing market participants to gauge the true value of an asset more accurately than in a simple AMM pool.

Limitations of AMMs

While AMMs are a powerful tool for liquidity provision, they also have limitations. This section discusses each limitation in detail.

Impermanent loss

• A major concern for LPs in AMMs is the possibility of impermanent loss, which can happen when the price of an asset changes significantly relative to the other asset in the pool. While impermanent loss can be mitigated through the use of concentrated liquidity, it is still a risk that traders must be aware of.

Concentrated liquidity

• Another limitation of AMMs is the concentration of liquidity in the pool. The more concentrated the liquidity, the lower the price impact and the higher the slippage. This can be mitigated through the use of multiple pools, but it still remains a challenge for traders.

Price impact

• A final limitation of AMMs is that they can suffer from higher price impact for large orders. This is a direct result of the constant‑product invariant, which means that the pool must be re‑balanced each time a trade is executed. The price impact can be mitigated through the use of multiple pools, but it still remains a challenge for traders.

Conclusion

CLOBs and AMMs are two complementary tools that offer traders different ways to interact with the market. While CLOBs are typically more efficient at facilitating high‑frequency trades and providing more accurate price discovery, AMMs can offer deeper liquidity and a more user‑friendly trading experience. The line between the two models will continue to blur as the market matures, leading to an ecosystem where users can trade seamlessly, safely, and at the best available prices.