Order types are missing from DeFi – why is no one talking about this?
12-07-2022AXO
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Trading when the internet goes out, holding assets while you sleep, and placing orders during high price volatility are all ways your assets could lose value in a market. How can you manage these risks and protect your profits or minimize losses?In Decentralized Finance (DeFi), you can’t — at least not yet.Every market participant is either looking to get into the market (buy) or get out of the market (sell). Order types define how this will happen, and the ‘how’ can make a big difference to a trader’s success and overall experience.Current generation Decentralized Exchanges (DEXs) have focused on solving peer-to-peer trading (P2P trading), it’s a good foundation, but it has come at the expense of order types. Order types are the language of market participants, conveying their true intentions and creating market sentiment. In traditional finance (TradFi) and on centralized exchanges (CEXs), order types allow market participants to manage risk, eliminate the need for constant supervision, increase privacy, manage multiple trades, and trade with precision.If we look at where the majority of transaction volume is, we can see a correlation between the functionality of exchanges and market participation (see graphic below).
(October 2021, Axo whitepaper p. 69.)Most trading volume is happening on TradFi exchanges, followed by CEXs, with trading volume on DEXs coming a distant last. Fewer people are trading on DEXs because it doesn’t provide them with what they need. DEXs only offer one order type — three at best — as opposed to hundreds offered by TradFi exchanges.Expanding the ways users can interact with the market (more order types) incentivizes higher market participation — as more people or institutions are able to manage their risk and trade how they want, the market opens up to a wider variety of market participants. The increase in market participants creates higher liquidity and more market information, which contributes to a tighter bid-order spread and stabilizes markets — encouraging further market participation.Without order types, we are sidelining billions of dollars (USD) in potential capital from market participants who do not have the tools they need to participate in DeFi. To Understand why market participants demand them and how creating them can exponentially expand DeFi, we need to look at the utility and purpose of order types for market participants.
Limit orders sit on the order book until a buy or sell order matches or beats its listed price, at which point the order begins to be filled. It might take one or multiple orders — depending on the volume of the limit order and the volume of the new orders — to complete a limit order and remove it from the order book. If there is not enough liquidity to support all the volume, the limit order remains on the market partially filled (less volume) but at the same price point. Traders can cancel a partially filled limit order at any time.Limit orders can automate a basic risk management strategy to preserve profits and limit losses (limit the impact of slippage). They guarantee a specified price or better (if executed) and, perhaps just as importantly, eliminate the need for the trader to constantly monitor a market to get that price. But, they are not a perfect strategy. If the order is not filled before the price moves away from the desired price, a trader may lose out on profiting on an upswing or exiting before a downswing. A trader that values the execution price over their desire to enter or exit a market will prioritize limit orders.Without limit orders on a DEX, there are no ways to guarantee a specific price, and the market sentiment is much more difficult to gauge without being able to see the limit orders waiting to be filled. For the majority of traders, a limit order is the bare minimum they need for trading — they are non-existent on most DEXs.
A market-if-touched order (MIT) is a condition placed on a market order set to execute at a trigger price. If a trader sets the trigger price below the current market price, they can leverage the strengths of a market order (guaranteed execution) to capture an asset at a lower price during a downward price movement. In this instance, the MIT effectively combines the benefits of guaranteed execution from a market order with the ability to specify (to a degree) a market entry price.
A limit-if-touched order (LIT) is a condition placed on a limit order to execute at a trigger price — the trader can specify both the trigger price and the limit price, giving them more flexibility. Suppose a trader moves a large amount of capital or trades in a market with low liquidity. In that case, a limit order can substantially impact the market value of an asset as its intent is revealed. To help mitigate the risk of price movement, a trader might want to hold out until a price moves closer to their desired price point before triggering their limit order to increase their chances of execution.
A stop-loss is one of the most common conditions in trading. It instructs a market order to execute at a trigger price set below the entry price (the price they purchased their asset). When a trader enters a market, they risk that the market value of their asset might drop. A stop-loss enables a trader to set how much loss they are willing to accept before exiting the market. Because a stop-loss executes a market order, execution is guaranteed, but the price may still drop as the order is filled.
A trailing stop loss is a slightly more complex price condition. It instructs a market order to execute if the price of an asset moves beyond a specified threshold. This enables a stop loss to follow market value until there is a significant enough price movement to trigger the market order. A trailing stop loss enables a trader to potentially get a better price than their initial preferred price as the market moves more steadily in the direction they anticipate.Though price conditions can help with risk management relating to price movement, they do not negate the intrinsic risk of market orders (price not guaranteed) or limit orders (execution not guaranteed).
Above, we discussed conditions that either help preserve profits, prevent losses or initiate an order at a desired price point. A bracketed buy order is an example of a single order that combines different order types to reap their benefits. In a bracketed buy order, a market order is executed at a trigger price (much the same as an MIT) to buy an asset, but the trigger price also executes a sell-limit order priced above the trigger price and a stop-loss priced below the trigger price. The bracketed buy order specifies that the trader will buy the asset if the asset becomes available at a trigger price. If the price moves toward an acceptable profit level, or if the price moves below an unacceptable loss level, they will then sell the asset. This type of trade ensures that the trader can roughly estimate what their profit or loss would be if their initial buy order is fulfilled.The most advanced trading platforms enable traders to create their order types directly through their API. Not only can they automate redundant, time-consuming tasks, but they can integrate information from outside of a trading platform, like indexes, oracle, news patterns, weather data, and more, to create hypercomplex and high-frequency trading strategies. In professional circumstances, algorithms using the order types and conditions of exchanges can execute roughly 40,000 trades per millisecond across many markets. These types of advanced order types with time and price conditions can be executed through automation as such high trading volume is impossible to be overseen by humans.