DEXs (Decentralized Exchanges) are outpacing the growth of CEXs (Centralized Exchanges), and it is possible that soon, DEXs could outpace centralized transaction volume. Although DeFi developers are building new tools for DEX users, there are still considerable infrastructure limitations on DEXs. Until these limitations are addressed, DEX growth will be limited, and DEXs will be less useful for retail investors and institutions.
This article will focus on conditional orders and why they are an important feature set for DEXs.
What is a conditional order?
A conditional order allows you to set order triggers for assets based on price movement or other criteria. This applies to traditional finance (like stocks or options contracts) and DeFi (tokens, NFT’s, etc.). The most common conditional order is a limit order, which is an order that will only be executed if the target asset can be acquired at or below a specific price.
Conditional orders quickly become more complex and can incorporate several factors. This article goes into detail about many types of conditional orders and is a great resource for anyone looking to learn more. You can also read Binance’s explainer on different order types.
Benefits of Conditional Orders
Conditional orders are a tool in the investor’s playbook. There are three main benefits to conditional orders:
Maximize profit and mitigate risk
It’s important to recognize that conditional orders don’t guarantee higher returns. However, they can help maximize profit and mitigate risk by enforcing a predetermined trading strategy. Investors and traders are often their own worst enemy due to emotional reactions to volatility. A common conditional order called the stop loss can automatically initiate the sale of an asset if the price drops below x% from the purchase price. This is a great tool to minimize downside risk.
No active monitoring is required
With conditional orders, active investors don’t have to constantly monitor asset pricing to take advantage of price fluctuations. As one DeFi user told Brink: “If I could submit something as basic as limit orders on a DEX, I could input all my trades in the morning and then sit by the pool for the rest of the day.”
Remove the risk of slippage
When DeFi users trade illiquid tokens or transact in large amounts, they often have to worry about slippage. Simply put, slippage is when a trader ends up receiving less of the token they’re purchasing due to an increase in that token’s price. This occurs when the trader’s trade is large enough to move the token’s price unfavorably for the trader. Traditional equities markets are liquid enough that a very large transaction will not substantially alter the asset’s price. But what about a 1 Million DAI -> ETH transaction on Uniswap? As of today (12/21/20), that trade would impact the price by 1.6% or 16,000 DAI, a non-trivial amount. Limit orders remove this risk and guarantee that a user will receive the set limit price. This is extremely relevant for institutions/whales (more on that later).
DeFi Specific Conditional Orders
DeFi offers new and exciting ways for investors to make money. One of the most popular strategies is Yield Farming. In exchange for providing liquidity to a market, yield farmers are often compensated in highly speculative reward tokens like $SUSHI or $FARM. These tokens are extremely volatile and are not always safe to hold for long periods of time. The process of Yield Farming is currently very hands-on, and users need to actively manage their funds.
A sophisticated platform could partially automate this process and help users mitigate the risk of holding a speculative token. With conditional orders, a Yield Farmer could authorize a protocol to automatically sell the reward token after it’s accumulated a certain level of value.
The possibilities are virtually endless, and a sophisticated investor could specify a nearly infinite number of conditions for the conditional order to be executed. Consider the following transaction:
A Yield Farmer uses the SushiSwap protocol to provide liquidity to the SUSHI<>ETH pair. That farmer is rewarded in $SUSHI, a volatile, low market cap token. In addition to being rewarded with a highly speculative token, the Farmer also faces the risk of impermanent loss if the price of $SUSHI or $ETH drastically changes while their liquidity is in the protocol. To minimize the risk of impermanent loss, that Yield Farmer could submit a conditional order that constantly monitors the price of $SUSHI and $ETH. If either token’s price fluctuates by x%, the provided liquidity is immediately pulled from the liquidity pool and swapped to a stablecoin. this could all be conducted while the Farmer maintains full custody of their tokens.
This is extremely valuable for DeFi users. Automated orders will drastically mitigate their risk and lower their workload.
Institutional Demand for Conditional Orders
There is growing interest in DeFi from institutions. Research from BCG and Crypto.com indicates that “86% of financial institutions in Europe are implementing or assessing services built on the DeFi framework” (Yahoo News).
Although DEX volume has increased and pricing has improved, which has attracted institutional interest, institutions and whales rely on conditional orders to make transactions. This is likely keeping a significant amount of transaction volume from happening on DEXs. Although exact numbers are difficult to come by, research suggests that 95% of institutional equity volume uses conditional orders. This is because “Conditional orders allow portfolio managers to search for hidden block liquidity without fully committing to trade, as they allow the trader to represent larger orders in multiple venues without the risk of being simultaneously executed in multiple trading venues.” (The Trade) Currently, there is no way to execute stop-loss or other complex conditional orders in DeFi, and the few apps that support limit orders have restrictions on supported markets.
DeFi Specific Challenges
For conditional orders to fit into the DeFi ecosystem, they need to be permissionless, non-custodial, and decentralized.
Any individual or entity must be allowed access to a protocol that introduces conditional orders.
While a centralized platform like Binance can easily implement conditional orders that take full-custody of user assets, a DeFi platform for conditional orders must ensure that users maintain custody of their assets at all times.
No single entity should control a protocol that enables conditional orders. The protocol should work autonomously without any entity’s oversight, and the project should be controlled by the community at large.
Conditional orders will be the largest driver of volume growth in DEXs. In US equities markets, institutions accounted for about 90% of the stock market’s activity in 2019 (Business Insider). They will likely make up a significant percentage of DEX volume once the appropriate tools have been developed.
To highlight this, consider how analysts and institutions think about crypto as an asset class. In general, crypto is seen as a hedge against inflation and a hedge against market risk. This means that engaging in large, quick trades between assets like USDT (a stablecoin pegged to the USD) and Ethereum or WBTC would be valuable to institutions. How much more effective would those transactions be if a platform existed that automatically executed trades based on the fluctuating demand for USDT or other market indicators?
At Brink, we are building critical infrastructure for conditional orders on DeFi. Brink is a fully permissionless, decentralized, and community-driven project that allows users to execute conditional orders against any on-chain liquidity source.
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We’ve done our best to deploy secure code, but Brink has not been audited by a 3rd party. Like any Dapp, use caution, and be aware that there is always a risk of fund loss.