Liquidity Game: Technological Innovation and Power Redistribution of DEX

In the cryptocurrency market, retail investors are often seen as the "bag holders" when institutional investors exit. This asymmetry is even more pronounced in the cryptocurrency space, where the market-making mechanisms of centralized exchanges and dark pool trading exacerbate the information gap. However, with the development of decentralized exchanges, new order book DEXs represented by dYdX and Antarctic are reshaping the distribution of liquidity power through innovative mechanisms. This article will analyze how excellent DEXs achieve effective isolation of retail and institutional liquidity from the perspectives of technical architecture, incentive mechanisms, and governance models.

Liquidity Layering: From Passive Burden to Power Restructuring

The liquidity dilemma of traditional DEX

In early automated market maker models, retail investors faced significant adverse selection risks when providing liquidity. Taking a certain DEX as an example, although its concentrated liquidity design improved capital efficiency, data shows that the average position of retail LPs is only $29,000, primarily distributed in small pools; while professional institutions dominate large trading pools with an average position of $3.7 million. Under this structure, when institutions make large sell-offs, retail liquidity pools bear the brunt of price declines, forming a typical "exit liquidity trap."

The necessity of liquidity tiering

Research shows that the DEX market has clearly exhibited a specialization stratification: while retail investors account for 93% of the total number of liquidity providers, 65-85% of the actual liquidity is provided by a small number of institutions. This stratification is an inevitable result of optimizing market efficiency. Excellent DEXs need to manage the "long-tail liquidity" of retail investors and the "core liquidity" of institutions through mechanism design. For example, a DEX has launched a liquidity pool mechanism that algorithmically allocates stablecoins deposited by retail investors to institution-led sub-pools, which not only ensures liquidity depth but also avoids direct exposure of retail investors to large trade impacts.

Technical Mechanism: Building a Liquidity Firewall

Innovation of Order Book Model

DEXs that adopt order books can build a multi-layer liquidity protection mechanism through technological innovations, with the core goal of physically isolating retail liquidity demands from institutional large trading behaviors, preventing retail investors from becoming the "victims" of market volatility. The design of the liquidity firewall needs to balance efficiency, transparency, and risk isolation capabilities, focusing on a hybrid architecture that combines on-chain and off-chain collaboration, ensuring user asset autonomy while resisting the impact of market fluctuations and malicious operations on the liquidity pool.

The hybrid model processes high-frequency operations such as order matching off-chain, leveraging the low latency and high throughput characteristics of off-chain servers to significantly enhance trade execution speed and avoid slippage issues caused by blockchain network congestion. At the same time, on-chain settlement ensures the security and transparency of self-custodied assets. Multiple DEXs match trades through an off-chain order book, completing the final settlement on-chain, which retains the core advantages of decentralization while achieving trading efficiency close to that of centralized exchanges.

The privacy of off-chain order books reduces the pre-exposure of transaction information, effectively suppressing MEV behaviors such as front-running and sandwich attacks. The hybrid model allows access to professional algorithms of traditional market makers, managing off-chain liquidity pools flexibly, providing tighter bid-ask spreads and depth. A certain protocol adopts a virtual automated market maker model, combined with an off-chain liquidity replenishment mechanism, alleviating the high slippage issues of pure on-chain AMMs.

Off-chain processing of complex calculations (such as dynamic funding rate adjustments and high-frequency trading matching) reduces on-chain gas consumption, with only key settlement steps needing to be processed on-chain. The single contract architecture of a certain DEX merges multiple pool operations into a single contract, further reducing gas costs by up to 99%, providing a technical basis for hybrid model scalability. The hybrid model supports deep integration with DeFi components such as oracles and lending protocols. A certain trading platform uses oracles to obtain off-chain price data, combining it with on-chain clearing mechanisms to achieve complex functionalities in derivatives trading.

Build liquidity firewall strategies that meet market needs

The liquidity firewall aims to maintain the stability of liquidity pools through technical means, preventing systemic risks caused by malicious operations and market fluctuations. Common practices include introducing a time lock (such as a 24-hour delay, up to a maximum of 7 days) when LPs exit, preventing high-frequency withdrawals from causing an instant depletion of liquidity. During severe market fluctuations, the time lock can buffer panic withdrawals, protecting long-term LP returns while transparently recording the lock-up period through smart contracts to ensure fairness.

Based on real-time monitoring of liquidity pool asset ratios by oracles, exchanges can set dynamic thresholds to trigger risk control mechanisms. When the proportion of a certain asset in the pool exceeds the preset upper limit, related trading is suspended or a rebalancing algorithm is automatically invoked to prevent the expansion of impermanent loss. Tiered rewards can also be designed based on the LP's lock-up duration and contribution. LPs who lock assets for a long time can enjoy higher fee-sharing or governance token incentives, thereby encouraging stability. A new feature of a certain DEX allows developers to customize LP incentive rules (such as automatic reinvestment of fees), enhancing stickiness.

Deploy a real-time monitoring system off-chain to identify abnormal trading patterns (such as large-scale arbitrage attacks) and trigger an on-chain circuit breaker mechanism. Suspend trading for specific trading pairs or limit large orders, similar to the "circuit breaker" mechanism in traditional finance. Ensure the security of the liquidity pool contracts through formal verification and third-party audits, while adopting a modular design to support emergency upgrades. Introduce a proxy contract model that allows for vulnerabilities to be fixed without migrating liquidity, avoiding the recurrence of similar major events.

Case Study

A DEX: A Complete Decentralized Practice of Order Book Model

The DEX maintains the order book off-chain, creating a hybrid architecture of off-chain order books and on-chain settlement. A decentralized network composed of 60 validator nodes matches trades in real-time, and the final settlement is completed on an application chain built with a specific SDK only after the transaction is executed. This design isolates the impact of high-frequency trading on retail liquidity off-chain, with only the results processed on-chain, avoiding direct exposure of retail LPs to price fluctuations caused by large order cancellations. The gas-free trading model charges fees proportionally only after a successful transaction, preventing retail investors from incurring high gas costs due to frequent order cancellations and reducing the risk of passively becoming "exit liquidity."

When retail investors stake tokens to receive a stablecoin yield of 15% APR (from trading fee sharing), institutions need to stake tokens to become validation nodes, participating in off-chain order book maintenance and obtaining higher yields. This layered design separates retail earnings from institutional node functions, reducing conflicts of interest. Permissionless token listing and liquidity isolation allocate stablecoins provided by retail investors to different sub-pools through algorithms, avoiding a single asset pool being penetrated by large trades. Token holders decide on parameters such as the allocation ratio of transaction fees and new trading pairs through on-chain voting, preventing institutions from unilaterally modifying rules to harm retail interests.

A stablecoin project: Stablecoin Liquidity Moat

When users collateralize ETH to generate Delta-neutral stablecoins, the protocol automatically opens a corresponding short position in perpetual contracts for ETH on the exchange to achieve hedging. Retail holders of the stablecoin only bear the ETH staking yield and the funding rate spread, avoiding direct exposure to spot price fluctuations. When the stablecoin price deviates from $1, arbitrageurs need to redeem collateral through on-chain contracts, triggering a dynamic adjustment mechanism to prevent institutions from manipulating prices through concentrated sell-offs.

Retail investors pledge stablecoins to obtain yield tokens, with yields sourced from ETH staking rewards and funding rates; institutions, on the other hand, provide on-chain liquidity through market making to receive additional incentives, with the revenue sources of the two roles physically isolated. Inject reward tokens into a stablecoin pool on a certain DEX to ensure retail investors can exchange with low slippage, avoiding being forced to bear the institutional selling pressure due to insufficient liquidity. Future plans include controlling the type of stablecoin collateral and hedging ratio through governance tokens, allowing the community to vote to limit excessive leverage operations by institutions.

Some Protocol: Elastic Market Making and Protocol Controlled Value

After the protocol migrated to the new infrastructure, an efficient order book contract trading model was built with off-chain matching and on-chain settlement. User assets adopt a self-custody mechanism, and all assets are stored in on-chain smart contracts, ensuring that the platform cannot misappropriate funds. Even if the platform stops operating, users can still forcibly withdraw to ensure safety. Its contracts support seamless deposits and withdrawals of multi-chain assets and are designed without KYC requirements; users only need to connect their wallets or social accounts to trade, significantly reducing trading costs by exempting Gas fees. In addition, the protocol innovatively supports one-click buying and selling of multi-chain assets in spot trading, eliminating the cumbersome processes and extra costs of cross-chain bridging, making it particularly suitable for the efficient trading of multi-chain assets.

The core competitiveness of this protocol stems from the groundbreaking design of its underlying infrastructure. Through zero-knowledge proofs and the aggregated Rollup architecture, it addresses the issues of liquidity fragmentation, high transaction costs, and cross-chain complexity faced by traditional DEXs. Its multi-chain liquidity aggregation capability unifies assets scattered across various networks, forming a deep liquidity pool, allowing users to obtain the best trading prices without needing to cross chains. At the same time, zk-Rollup technology enables off-chain batch processing of transactions, combined with recursive proofs to optimize verification efficiency, making its throughput close to centralized exchange levels, with transaction costs being only a small fraction of similar platforms. Compared to some DEXs optimized for single chains, this protocol offers users a more flexible and low-threshold trading experience through cross-chain interoperability and a unified asset listing mechanism.

A certain exchange: The revolution of privacy and efficiency based on ZK Rollup

The exchange employs zero-knowledge technology, combining the privacy attributes of Zk-SNARKs with the depth of order book liquidity. Users can anonymously verify the validity of transactions (such as margin sufficiency) without exposing position details to prevent MEV attacks and information leaks, successfully addressing the industry's dilemma of "transparency and privacy cannot coexist." By aggregating a large number of transaction hashes into a single root hash on-chain through a Merkle Tree, it greatly compresses on-chain storage costs and on-chain Gas consumption. The coupling of Merkle Tree and on-chain verification provides retail users with a "no-compromise solution" that offers centralized exchange-level experience and DEX-level security.

In the design of the LP pool, the exchange adopts a hybrid LP model, seamlessly connecting users' stablecoin and LP Token exchange operations through smart contracts, while also taking into account the advantages of on-chain transparency and off-chain efficiency. A delay is introduced when users attempt to exit the liquidity pool to prevent instability in market liquidity supply caused by frequent entries and exits. This mechanism can reduce price slippage risk, enhance the stability of the liquidity pool, and protect the interests of long-term liquidity providers, preventing market manipulators and opportunistic traders from profiting from market fluctuations.

In traditional centralized exchanges, large fund clients need to rely on the liquidity of all users in the order book when exiting liquidity, which can easily lead to a cascade effect and price crashes. However, the hedging market-making mechanism of this exchange can effectively balance liquidity supply, ensuring that institutional investors do not overly depend on retail funds when exiting, allowing retail investors to avoid taking on excessive risks. This is more suitable for professional traders who prefer high leverage, low slippage, and are averse to market manipulation.

Future Direction: The Possibility of Liquidity Democratization

The future DEX liquidity design may develop along two branches: a global liquidity network and a co-governance ecosystem. The global liquidity network breaks down silos through cross-chain interoperability technology, maximizing capital efficiency, allowing retail investors to achieve an optimal trading experience through "seamless cross-chain". The co-governance ecosystem innovates through mechanism design, shifting DAO governance from "capital power" to "contribution rights", creating a dynamic balance between retail and institutional investors in the game.

Cross-chain Liquidity Aggregation: From Fragmentation to Global Liquidity Network

This path builds the underlying infrastructure using cross-chain communication protocols to achieve real-time data synchronization and asset transfer between multiple chains, eliminating reliance on centralized bridging. Through zero-knowledge proofs or lightweight node verification technology, it ensures the security and immediacy of cross-chain transactions.

By combining AI predictive models with on-chain data analysis, smart routing will automatically select the optimal chain's Liquidity pool. For example, when a mainnet asset sell-off leads to increased slippage, the system can instantly disassemble liquidity from low slippage pools on other chains and complete cross-chain hedging through atomic swaps, reducing the impact cost on the retail pool.

Another solution is to develop a cross-chain liquidity aggregation protocol that allows users to access multiple chain liquidity pools from a single point. The fund pool adopts a "liquidity as a service" model, allocated on demand to different chains, and automatically balances price differences between chains through arbitrage bots, maximizing capital efficiency. At the same time, a cross-chain insurance pool and a dynamic fee model are introduced,