In this cycle, Binance has been criticized by the community for many reasons, but it still does not undermine its position as the world's largest exchange. Other centralized exchanges (CEX) have also been embroiled in a number of controversies, but Hyperliquid has quickly become the dominant on-chain exchange after issuing its token. With the rise of H-Bei (Hyperliquid community), the author would like to discuss from two aspects: liquidity and risk. Are we heading towards the Hyperliquid era? What are the difficult-to-break moats of centralized exchanges?
Table of Contents
ToggleExchange’s Moat: Liquidity
According to Huobi co-founder Du Jun, trading bots such as GMGN are essentially securities firms, and the exchange’s moat lies in liquidity. When talking about liquidity, the key is market makers. Generally speaking their job is to provide liquidity and ensure that price fluctuations are smoothed out. And arbitrage in CEX and DEX, and earn price differences and transaction fee subsidies.
The founders of Binance, FTX, and Hyperliquid all come from high-frequency trading and market making backgrounds. Back to the issue of liquidity, the most basic principle of derivatives trading is that "every short position corresponds to an equal long position", which means that if a BTC long order is placed now, there must be a matching short order to complete the order, and this is liquidity. If those who are familiar with CEX have no idea, just find a Perp DEX and place an order for a small coin and you will understand. Either the order cannot be executed or the price slippage is too large.
Back to the concept of trading, short positions must correspond to an equal number of long positions. Sometimes the trend is obvious, and the positions of short and long positions cannot match. At this time, the exchange will automatically reduce your position. In some ways, this can also be regarded as a problem of insufficient liquidity.
KOL provides a simple way to determine whether it is internal market making
This round of wealth-creating effect is concentrated on the chain, especially the meme coins that are springing up like mushrooms after rain. Binance is most often criticized for its inability to list coins quickly enough to keep up with new hot spots. According to He Yi, this is largely a regulatory issue, but on the other hand, who wants to be the counterparty for these meme coins? Other competitors list their coins very quickly, so it is indeed possible to do some operations in these small exchanges. Now let’s talk about another way of liquidity: internal market making.
Internal market making is also known as a betting exchange or a customer loss exchange. Simply put, trading in this kind of exchange means the exchange is betting against you. After all, in a casino, the chances of gamblers losing are nine out of ten. The reason why some exchanges mind being called customer-loss exchanges is that trading here is like plucking a lion's mane, and the interests of gamblers are relative to the exchange itself. The money you earn is taken from the exchange. Normally, the exchange makes money, but what if it is an abnormal trading event?
@iamdoublewan, a KOL who started out as a quantitative trader, gave a simple way to judge : if you see a second- or third-tier exchange whose order book depth is better than OKX, there is a high probability that it is a betting exchange.
So let’s summarize the liquidity solution. If it is a centralized exchange: One approach is to introduce third-party market makers such as Kronos, Jump Trading, and HRT. Another approach is to use the customer's exchange, where the exchange not only provides a trading venue but also acts as a banker. Of course, most of them may be a combination of both.
Hyperliquid combines order book and LP trading mechanism
Hyperliquid is probably the most powerful entity in the community in this cycle, and H-Bei’s cohesion can be called a belief. The rise of Hyperliquid is closely related to the following points:
- In an anti-VC market, no investor can operate an exchange.
- The valuation of Hyperliquid is the exchange plus the public chain.
- The founder Jeff is from the quantitative trading giant HRT.
- For VC coins with no revenue, there is actual profitability and a repurchase mechanism is introduced.
- This can be regarded as the most generous airdrop in 2024 or even in this cycle. Retail investors can become shareholders of an exchange at a very low cost. The network effect of community belief is very terrifying.
But long before Hyperliquid, there were Perp Dex like GMX and dydx. Why does Hyperliquid stand out? Here we have to mention Dex’s solution to liquidity.
- DYDX uses an order book system, which is actually the trading system of traditional finance and centralized exchanges. In this system, liquidity relies on market participants (users and market makers) to place orders.
- GMX introduces the LP concept. Simply put, users deposit money into LP. If someone trades on GMX, LP will act as the user's counterparty.
In a way, LP is equivalent to the customer loss exchange of CEX, but the LP provided by the users is also the one betting against the traders, and the profits also go into the pockets of LP. In this regard, since GMX, which provides a trading platform, does not directly gamble against retail investors, it is relatively uncontroversial. The advantage of using the LP system is that the transaction price does not depend on the order price, but on the oracle price, which is relatively flexible.
Hyperliquid combines the on-chain order book with HLP, and prioritizes matching the order book based on price and order time. If the order cannot be matched, HLP will serve as the counterparty.
Transaction chain and fair participation are the biggest keys
After talking about a few common mechanisms, let me talk about my feelings. Ask yourself, why do we need on-chain exchanges? After all, the reality is that whether it is user experience or liquidity, the leading centralized exchanges still have absolute advantages. I thought of a few points:
- Transactions on the chain are much more transparent than on the exchange server. Apart from being stabbed by CEX, if there are KOLs who claim to be very knowledgeable about trading, why not just come to Hyperliquid to try it out for real? The importance of transparency is extended here. Are there any unexpected events in the agreement? Hacked? When data is put on the chain, retail investors and protocol parties can reduce the information gap. One case is the stablecoin protocol Resolv Labs, which uses a fee arbitrage strategy and establishes some short positions on Hyperliquid, allowing everyone to track the health of their positions.
- Retail investors can also become market makers through the LP mechanism, which is fairer than centralized exchanges.
- No KYC required (although it doesn’t matter to me but there are many such needs in the world).
- Can be used to trade small coins in the ecosystem.
The JELLY incident highlights the risks of the LP mechanism
People often talk about decentralized exchanges, but are they too often putting decentralization and blockchain together? However, I think that in practice, the discussion on decentralization should be a question of degree rather than a binary discussion. In the case of Hyperliquid, there is indeed still a large degree of human intervention, but it may also be necessary for the current protocol. After all, as in the JELLY incident, HLP might have gone bankrupt without human intervention.
By the way, let’s use the JELLY incident to talk about the issue of risk-taking. The JELLY incident was that a certain address established a short order $JELLYJELLY on Hyperliquid and at the same time raised the spot price. At this time, the short order faces liquidation and HLP takes over the position. Regardless of the mechanism of CEX or Hyperliquid, LP will take over, because closing a short position is equivalent to buying in the market, but at this time the price of JELLY has skyrocketed and there are not enough short positions to match it.
After HLP took over the position, the market maker continued to pull up the price, which rose by 457% in just one hour. Ultimately, Hyperliquid decided to unplug the network cable and roll back the transaction. This incident highlights that when trading small coins, it is easy for the LP mechanism to find loopholes and drain the pool. However, similar incidents may also happen in CEX, but you may not know it because it is not as transparent as in Hyperliquid. Under the order book system, these transaction risks are borne entirely by market participants (market makers, retail investors).
Practitioners: Order book combined with LP actually has spread risk
The author asked Kyrie from Typus Finance why Typus chose the LP mechanism instead of Hyperliquid’s order book integrated LP. After all, there is Deepbook on Sui. In theory, doesn’t this increase liquidity?
He said that because the order book is combined with LP, in practice the liquidity of the order book must be matched first, and only when the match cannot be made will LP be used as the counterparty. At the same time, positions may be established on other exchanges to ensure that LPs remain neutral. However, if the price changes too much under the comprehensive mechanism, there may be a gap between the price at which users establish a position and the price at which LP sells the position risk.
When establishing a long order on a decentralized contract exchange, it will take a little time to match the order book to see if there is a sell order to match. If there is no LP, an equal sell order will be established to match. At this time, it may take a little more time to establish a buy order of the same position size at another exchange to ensure that LP is not holding a naked order in a specific direction. The time mentioned here may be less than a second, but the quotation in 0.1 second can make a big difference, and a pure LP strategy can reduce the risk.
On-chain markets are less attractive to market makers
Let’s get back to the topic. We mentioned earlier that centralized exchanges introduce third-party market makers to provide liquidity. Are there no market makers in decentralized contract exchanges? Actually, there is, but it is limited by:
- Given the risk control mechanism of the market maker itself, it is not as easy for the market maker to add a new chain of business as it is for retail investors.
- In fact, market makers are currently doing on-chain transactions, but they are mainly cross-exchange arbitrage transactions.
- Those who can trade on the chain basically have considerable trading experience. Therefore, the profits from being a banker are not as high as those from centralized exchanges. You can refer to the fact that the annualized LP returns of several decentralized exchanges are around 13%.
Lighter Active Market Making, Jupiter Combined Investment Portfolio
The author has recently done a brief study of several decentralized contract exchanges. I haven’t seen much discussion about the mechanism of Surf Protocol, but it seems to be taking the LP route. However, it seems that retail investors cannot invest in LP at present? The main purpose of this agreement is to change the exchange's profit model. No handling fees will be charged, but profits will be shared. In addition, as previously introduced, GTE, an exchange that combines the high performance of MegaETH to operate the on-chain order book, will also soon launch contract trading.
Another equally high-profile project is Lighter, which was invested by a16z. It is also a combination of order book and LP. What is particularly special is that the LP of Lighter is not a passive market maker, but is operated subjectively by the manager. Currently, this product requires an invitation code. With a small number of users, the LP funds have reached 20 million US dollars. It is worthy of attention, and I heard that there will be good news announced soon.
Solana's largest decentralized exchange Jupiter also uses the LP mechanism. The JLP token is composed of SOL, ETH, WBTC, USDC, and USDT, and also acts as the user's counterparty. The main reason is that Jupiter's current contracts only open SOL, ETH, and WBTC. The value of the JLP token comes from traders' profits and losses, fund pool opening fees, closing fees, price impact fees, borrowing fees, 75% of transaction fees, and changes in the value of its assets. Although the current U-based APY is about 18.5%, the JLP price has risen from the initial 1.47 to a peak of 4.85.
Ostium's dual-layer liquidity design aligns the interests of LPs and traders
Another interesting product is Ostium, which focuses on putting traditional financial products on the chain for contract trading. Its investors include former a16z partner, Coinbase CTO Balaji Srinivasan and Alliance DAO. When I see this product, the most immediate question I have is how to handle non-traditional financial trading hours? During Ostium's non-trading hours, only limit orders can be placed, and market orders are not allowed.
As for how Ostium solves the liquidity problem? Osmium also adopts a similar LP mechanism, but the difference is that Osmium divides the counterparties into two layers: Liquidity Buffer. When traders lose money, their losses are poured into this buffer pool. Conversely, when a trader makes money, the platform will prioritize taking money from this buffer pool to pay them their profits.
Therefore, under normal circumstances, traders' profits and losses are absorbed by this buffer pool. Losses accumulate into the pool and profits flow out of the pool. Over time, the buffer pool may accumulate funds (from traders' net losses and various fees) as a reserve for future payments to winning traders. It is worth mentioning that LP cannot directly access the funds in this buffer pool. It is purely a profit and loss buffer account of the system.
Basically, LP will only act as the counterparty when the buffer pool goes bankrupt. Normally, they will enjoy 50% of the opening fee and 100% of the liquidation fee. From the perspective of LPs, they are usually more like liquidity providers and insurers of the platform, enjoying stable fee income while bearing the risk of acting as counterparties in black swan moments. This arrangement is equivalent to providing LP with a "safety valve", which means that they do not directly confront traders under normal circumstances and only intervene when necessary.
With Liquidity Buffer as a buffer, LP does not need to bear the profit and loss of every transaction, but mainly relies on transaction volume to make money (handling fees). This means that LPs are more concerned about the trading activity of the platform rather than the individual profits and losses of traders. When trading volume increases and the number of users increases, the fees received by LP also increase, and everyone is happy. For traders, the platform does not have a strong motivation to directly profit from their losses. Instead, it hopes that they will trade more and stay for a long time. It can be said that Ostium tries to tie the interests of LPs and traders into the same boat.
Hyperliquid makes more than $500 million a year
In summary, the reason why Hyperliquid has created a craze is that retail investors believe that relative fairness is the key. From putting transactions on the chain to reduce the information gap between retail investors and exchanges, to the fairness of participating chips, all are unprecedented. In addition, it has no VC financing and is profitable in itself, which can be used to repurchase tokens, which is in sharp contrast to the high-FDV token unprofitable projects run by VCs. According to DefiLlama data , Hyperliquid's annual profit is estimated to be as high as US$520 million.
The LP mechanism does solve the problem of insufficient liquidity in the order book, and also provides retail investors with opportunities to participate in the market in disguise. However, the JELLY incident also revealed the loopholes of the LP mechanism when dealing with small coins, but I believe that a good mechanism is constantly being revised. At least, Don't Die.
However, apart from the mechanism, decentralized contract exchanges are still inferior to CEX in terms of asset initiative, just like Binance can continuously provide tokens TGE for projects, turning platform tokens into gold shovels and increasing the number of users. Hyperliquid is still slightly at a disadvantage in this regard, but this round of wealth-creating effect returns to the chain, which is a good thing for Hyperliquid. Hyperliquid also has a transparent auction listing mechanism.
Other issues include: it is still not user-friendly enough for users who are accustomed to centralized exchanges. If small coins are not listed, there will be no advantage in trading items. Listing small coins also presents the risk of price manipulation. However, Hyperliquid's trading volume of $32.3 billion in the past week is already among the best performances among centralized exchanges. More importantly, it is still unrivaled in terms of fairness, no VC involvement, and perfect mechanism. Perhaps we can focus on the HyperEVM ecosystem.
Risk Warning
Cryptocurrency investments carry a high degree of risk, their prices may fluctuate dramatically, and you may lose all your investment. Please assess the risks carefully.
