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CryptoEconomic Research

Serum: A Decentralized On-Chain Central Limit Order Book

Serum is a highly performant and scalable decentralized exchange (DEX) built on the Solana network that utilizes a central limit order book (CLOB) rather than an automated market maker to power its trading infrastructure.
by David ShuttleworthFebruary 25, 2022
Serum DeFi Protocol Profile

Serum is a decentralized exchange (DEX) built natively on Solana that utilizes an order book model rather than an automated market maker (AMM). The core design of Serum is centered around its on-chain central limit order book (CLOB) which is similar to such mechanisms found within traditional finance, but is fully decentralized and permissionless, allowing users to circumvent a middle-party and interact directly with a smart contract to execute trades from an order book. This gives Serum a unique advantage over most existing DEX protocols and paired with the high speed and low cost of Solana, it allows Serum to function efficiently. In addition, Serum is interoperable with Ethereum and facilitates more composability within the DeFi ecosystem by enabling other protocols to interact with its order book to share liquidity and seamlessly build on top of it.

Overview

The shortcomings of centralized exchanges are well-documented. They require an intermediary for order book management and execution, are exposed to various security risks such as the retention of private keys, and ultimately are slower and more expensive than a DEX. However, one particularly useful feature of their design is the CLOB model, which lets users transparently match their orders with one another on a “price-time-priority-basis.” In short, the highest bid and the lowest ask converge to represent the current market price, and users have the option to cross this bid-ask spread to immediately execute the order. Given the transparency of this system, users can see market depth in real-time. While these features of a CLOB are quite powerful, they are difficult to implement within an on-chain system. This difficulty stems primarily from high throughput and low execution cost requirements of an order book. That is, in order for a CLOB to effectively operate on-chain, gas fees must be cheap and transactions must be very fast. 

Many of the first DEX protocols recognized these challenges and attempted to replace the traditional CLOB model through the implementation of an AMM. Uniswap pioneered this approach, and under their AMM system, DeFi users were able to quickly execute trades at a very low cost. However, several core functions of an order book, such as limit orders, bids, and offers were missing. In addition, liquidity providers were required to provide liquidity to both sides, were not able to choose to only provide liquidity at a particular price, and could not provide liquidity at a price other than the current market price. So the benefits of an AMM model come with certain tradeoffs. 

Serum has developed a fully decentralized, on-chain order book that allows users to execute orders directly with a smart contract while still enabling flexibility with pricing and order sizes. Its CLOB and matching engine provides both liquidity and price-time-priority-basis matching to users, enabling them to choose the price, size, and direction of their trades just as they would when interfacing with a traditional CLOB, but without all of the associated inefficiencies. Moreover, other protocols within the space can utilize Serum for bootstrapping liquidity and matching services, adding an additional layer of composability.

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Building on Solana allows Serum to harness the network’s high throughput and low transaction costs to power its order book functionality and further improve capital inefficiency and liquidity segmentation, all while remaining interoperable with Ethereum. Serum’s CLOB is designed to be asset agnostic and can construct an order book that matches any Solana-based trading instrument such as options and futures, and is comprised of other powerful features such as cross-chain swaps (e.g. ETH and BTC). It can also extend its backend matching engine to essentially any financial or non-financial instrument, making the protocol decidedly composable and enabling a wide range of applications and participants to share middleware in one place. Overall, the design of Serum’s architecture makes it more suited to modularity and gives external applications more flexibility.

By creating an order book that is fully on-chain, Serum has unlocked many of the core benefits associated with traditional order books to the DeFi ecosystem while preserving the efficacy of decentralized exchanges. Moreover, this approach enables other applications to connect to Serum and leverage its infrastructure to build their respective project, such as a trading application that utilizes the liquidity on Serum.

Mechanism Design and Tokenomics

$SRM is the native token of the Serum protocol and is used for trading fee discounts and governance. Overall, there is a total supply of 10,000,000,000 tokens. Token holders can receive up to 50% off trading fees and can participate in limited governance on the protocol such as voting on proposals to change fee parameters and distributions.

In addition, MegaSerum ($MSRM) is the protocol’s secondary native token and is designed to further encourage $SRM staking as well as a baseline requirement for running a node on the Serum network. In short, users that stake 1,000,000 $SRM tokens can redeem 1 $MSRM token. Holding this $MSRM token enables users to collect boosted fees from the protocol. Moreover, it allows them to be eligible to run a node on the network. Overall, $MSRM token supply is capped at 1,000 which creates an interesting mechanism around node scarcity and $SRM demand.

Serum incentivizes staking by distributing 20% of the fees generated by the exchange to token holders that stake $SRM. As a means of curbing token inflation, the protocol executes a token buy back and burning initiative each week. More specifically, the remaining 80% of the revenues generated by the exchange are used by the protocol to buy tokens back from circulation and burn them.  The fee design is structured so that 100% of the fees generated from the exchange flow back into $SRM, whether through staking rewards or through the weekly token buy back and burn programs. 

Serum’s token distribution model follows a linear unlock schedule in which 10% of the initial supply (i.e. 1,000,000,000) is unlocked at mint. The remaining tokens follow the same token unlock schedule in which they are fully locked for the first year and then become unlocked over the next 6 years. Unlocks began on  8/11/21 and runs through 8/11/2027.

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Macro View

Current TVL in Serum is $799M (as of 2/25/22), which puts Serum at #43 in terms of TVL in DeFi and it 24 hour on-chain trading volume is around $520M.

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Source: https://defillama.com/protocol/serum

Interestingly, Serum has considerably less asset types traded on its platform (currently 71 unique tokens at the time of writing) compared with some of its competitors such as Unisawp and PancakeSwap (647 and 4322 unique tokens, respectively). However, it is able to maintain significant trading volume, with $SOL-$USDC being the most frequently traded pair, and is within the top 5 most active DEXes.

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Source: https://coinmarketcap.com/rankings/exchanges/dex/

Despite significant differences in 24 hour trading volume compared with the leading DEX, Uniswap, $SRM and $UNI have become quite coupled over time. As more protocols launch one the Solana network, this could impact the trading volume on Serum. In addition, as Serum develops relationships with other protocols within the Web3 ecosystem, lending its infrastructure to bootstrap different liquidity programs, this could also have upward pressure on trading volume.

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Source: www.tradingview.com

One potential risk, however, is directly related to Solana. While Solana provides the horsepower for the Serum engine to function, $SOL also represents the token with the highest volume traded on the protocol. Currently, $SOL makes up about 82% of the total daily volume on Serum. So in this way, Serum’s fate is duly tied to the success of Solana.

Another risk comes from the token unlock schedule design. In short, there are a tremendous amount of tokens locked at genesis (i.e. 90%). These tokens sit idly and provide no value to the development of the Serum ecosystem. Moreover, each year essentially 1,000,000,000 enter into circulating supply and place considerable inflationary pressure on the token, particularly in the early years. For instance, the circulating supply doubles in Year 2. This presents a dilution problem for token holders, disproportionately distributed over the course of a 6 year unlock program.

Further Reading and Sources
  1. https://docs.projectserum.com/introduction/overview 
  2. https://whitepaper.io/document/626/serum-whitepaper 
  3. https://coinmarketcap.com/exchanges/serum-dex/ 
  4. https://projectserum.medium.com/srm-unlock-8e74f23d829f 
  5. https://projectserum.medium.com/an-ultimate-vision-for-serum-473a16e77201 

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