Serum: Return of the Order Book

The following report was written by Messari Hub Analyst(s) and commissioned by Serum, a member of Messari Hub. For additional information, please see the disclaimers following the article

Decentralized finance (DeFi), in just over a year, has “remixed” various elements of traditional finance (TradFi), including lending, derivatives, structured products, and more. But one element has yet to fully cross the chasm: order book exchanges.

Enter Serum, a Solana-based decentralized exchange seeking to reinvent the way assets are traded in the decentralized economy. Their “central limit order book”—a fully on-chain, highly scalable order-matching mechanism—could power the next generation of interchange, from in-game marketplaces to high-frequency trading. To better understand the promise and risks of this ambitious project, let’s take a look at the broader decentralized exchange landscape, how Serum fits into it, and what the protocol’s tokenomics (SRM) means for investors.

History of Decentralized Exchanges

Most asset trading today, from stocks on the NASDAQ to cryptocurrencies on Coinbase, is facilitated through order books. The mechanics of an order book are simple. A trader can place an order—specifying the trading pair, quantity, and price—which is matched with the other side of the order book. In aggregation, the book’s liquidity efficiently matches buyers and sellers.

There’s a reason why the vast majority of assets today are exchanged through this mechanism. For one, order books give users the ability to define their own price, even allowing them to place stop-loss and stop-limit orders. They also typically offer efficiency benefits for both traders (i.e., tighter spreads) and liquidity providers (i.e., no impermanent loss).

In the early days of decentralized finance (DeFi), a number of decentralized exchanges (DEXes) attempted to replicate this order book model in a trustless, on-chain manner. Starting in 2012, LocalBitcoins launched one of the first DEXes for transacting Bitcoin in a peer-to-peer way, powered by an on-chain escrow technique named Hashed Time Locked Contracts. In 2016, following Ethereum’s smart contract functionality, EtherDelta released an order book exchange. Numerous decentralized order book exchanges were subsequently launched, including IDEX and 0x, which continue to process hundreds of millions of dollars in volume to this day.

Today, however, the vast majority of DEX volume is settled through automated market makers (AMMs), not order book exchanges. In fact, over 90% of trades are routed through Uniswap, Sushiswap, or Curve, each representing AMM-based protocols. How did this come to be?

The answer lies mostly with implementation. Faced with high transaction costs and slow settlement speeds, AMM-based protocols have been easier to implement on smart contract networks like Ethereum than order book exchanges. AMMs also present certain advantages, such as guaranteed trade settlement, constant liquidity (particularly useful for long-tail assets), and a familiar “vending machine” user experience. They also have disadvantages, such as having higher slippage than order books and, most notably, impermanent loss diminishing the returns for liquidity providers.

However, with the progression of layer-2 scaling on Ethereum and the adoption of high-throughput chains like Solana, we are due for a new approach to this problem. There’s room for an emerging order book exchange that is fully decentralized, capital-efficient, and appealing to retail users.

Serum: An Order Book Paradigm Shift

In August 2020, at the tail end of Ethereum’s so-called “DeFi Summer,” Serum was launched as one of the first major projects on Solana. It was incubated and strongly supported by the Solana Foundation, Alameda Research, Sam Bankman-Fried, and several others.

The project was built in response to many of the problems the team saw in DeFi at the time. Ethereum’s limitations made it slow and expensive, many protocols were de facto centralized, and there was (and remains) a lack of cross-chain functionality. The whitepaper’s section on AMMs takes note of this:

• Uniswap has quietly revolutionized DeFi by allowing trading without orderbooks.
• But the more remarkable thing is that Automated Market Making is necessary. AMM is a system where there are no limit orders, or even bids or offers; in an orderbook, you can decide the price, size, and direction you want to trade. There are lots of disadvantages to AMM. You can’t provide liquidity unless you provide both sides; you can’t choose to only provide at a particular price; you can’t provide at a price other than the current market price; and you can’t choose the size to provide there without providing way more behind it.
• There’s a solution to this—it’s what the rest of finance does. But DeFi doesn’t have orderbooks, by and large, because the ETH network is too slow and expensive to support them. Matching bids and offers with each other involves a bunch of operations.

Serum, at its core, is a fully on-chain order book built on Solana. The protocol’s first-of-its-kind central limit order book (CLOB) is the technology that enables users to trade with each other in an efficient, trustless, and non-custodial way. The protocol is also asset-agnostic, which means any crypto-assets (spot, derivatives, synthetics, and so on) can be traded on the order book. In fact, an upcoming upgrade called Serum Core will make the order book capable of order-matching any financial asset, not just SPL tokens. This protocol improvement will make it even easier to build derivatives and complex products on Serum.

The decision to build on Solana is central to the protocol’s mechanism. Solana’s quick settlement speed allows for sub-second trading, which is necessary for a well-functioning order book, and the low network fees (on the order of $0.00001 per transaction) enable inexpensive on-chain interaction.

While most of the protocol’s mechanics are directly executed on-chain, Serum also plans to have a network of nodes responsible for “turning the crank,” which involves order-matching and occasionally running specific programs. Nodes, in return for their work, would be allocated a share of the protocol’s revenue and are afforded governance responsibilities.

Serum, as one of the first and most successful DeFi projects on Solana, has established itself as a major player in the ecosystem. The protocol’s early bet on Solana seems to have paid off; Solana’s DeFi ecosystem has blossomed from merely $500M in late June 2021 to nearly $14B today.

Liquidity as a Service

To best understand Serum, it’s useful to treat it as more of an order book middleware solution than a decentralized exchange itself. While Serum has numerous front-ends for its own exchange (referred to as Serum DEX), its open-source nature allows DeFi protocols, games, dApps, and other projects to plug into Serum’s network of liquidity to power their own exchanges or marketplaces.

In fact, many of Solana’s top DeFi protocols are powered by Serum’s order book on the back-end. For example, Raydium, Atrix, and Mango Markets are each built on top of Serum’s open-source DEX infrastructure. While they have designed a unique graphical user interface (GUI) and, in many cases, have implemented new DeFi features (AMM functionality, new asset types, cross-chain, etc.), Serum is an integral part of their protocol architecture. As DeFi on Solana continues to mature, many expect Serum’s integrations to continue expanding.

Since Serum takes a small transaction fee on the liquidity it routes, it begs the question: Why don’t these protocols build their own on-chain order book?

The answer is two-fold. First, bootstrapping an on-chain order book isn’t easy—the technological and liquidity challenges on their own are enough to discourage many teams from trying. Secondly, and where the protocol’s true value lies, Serum gives DeFi protocols a network of liquidity that they can each tap into, resulting in cost savings and UX improvements for their users.

To visualize this, imagine there being two Serum-powered protocols, DEX A and DEX B. A user of DEX A could place a sell order on the Serum order book, which is then filled by a user of DEX B, without them ever knowing that they interacted with each other. In fact, cross-protocol interactions like these happen constantly between users of different projects in the Serum network since they all utilize the same pool of liquidity. This “liquidity network effect” increases the market depth and capital efficiency for everyone involved.

On Traction and Defensibility

In just over a year since Serum’s launch, it has cemented itself as perhaps the most important piece of DeFi infrastructure on Solana to date. The protocol itself directly captures $1.62B in total value locked (TVL), making it the second-largest DeFi project on Solana. In addition, SRM, Serum’s native token, is held by over 35,000 unique wallets, far higher than many other protocols.

Most impressive is how it has become the DEX middleware of choice for many of the ecosystem’s most successful projects. Raydium, an order book AMM with over $2B in TVL and $28B in total trading volume, is powered by Serum. Atrix, another “Serum AMM” with nearly $500M in TVL, also composes directly with the protocol. There are too many others to name.

In sprawling its tentacles across Solana-based projects, Serum has delivered on its promise to be the core liquidity pool of the ecosystem. And, since much of the project’s value comes from these powerful network effects, Serum is well-positioned to defend against new competitors.

As the ecosystem goes cross-chain, Serum will need to level up. The project’s original whitepaper placed enormous emphasis on the promise of cross-chain swaps and contracts, identifying them as two of the project’s “seven main ingredients.” However, after nearly a year these features have yet to be deployed.

Despite the delay, Serum could have new cross-chain initiatives up its sleeve. They recently announced intentions to build cross-chain infrastructure in conjunction with the Wormhole bridge to facilitate cross-chain liquidity, which would be a big step forward for the ecosystem. They are also partnering with Raydium to provide yield on cross-chain assets. While the cross-chain space is chock-full of competitors, old and new, Serum’s existing liquidity and the advantages of the Solana blockchain could give them the edge they need.

One thing’s for sure: we’re gearing up for an interesting next few quarters of DeFi innovation—on Solana and broadly—and Serum’s going to have to continue to fight to maintain their position. Successfully executing their cross-chain strategy could be the decisive factor of their future trajectory.

Under the Hood of SRM Tokenomics

Serum has two types of tokens: Serum (SRM) and MegaSerum (MSRM).

Serum (SRM) is the protocol’s primary native asset. It’s native to the Solana blockchain (as an SPL token), but is also tradable as an ERC-20 token. Three elements give the token value. First, SRM tokenholders pay lower fees on Serum-powered transactions, proportional to the SRM holdings in their wallet. For example, a non-SRM-holder would pay 22bps as a taker, whereas a wallet that holds 1,000 SRM would pay 18bps, saving 4bps. Second, SRM is also the protocol’s governance token. While on-chain governance hasn’t been fully deployed yet, SRM tokenholders have already begun to propose and vote on grant proposals, changes to the protocol’s fee structure, and more.

The third, and most direct, form of value accrual to the token comes from the protocol’s fee revenue. The protocol’s revenue is allocated as follows: 20% to the GUI or project (e.g., Raydium) and the remaining 80% to “buying-and-burning” SRM.

The buy-and-burn model is a simple yet powerful way of aligning token value with Serum’s usage. Each week, a smart contract collects 80% of the period’s revenues, purchases SRM on the open market, and burns the tokens. This results in a “dividend” of sorts for tokenholders, countering token emission and driving long-term value. Ever since Binance popularized the burn mechanism, it has been commonly used by protocols of all kinds, particularly revenue-generating exchanges like Serum.

As of writing, 2,437,373.95 SRM have been burned this year, equating to nearly $15M USD in value burned (accounting for weekly price changes). On average, about $350K in SRM is burned per week. The buy-and-burn program, as anticipated, correlates highly with Serum’s DEX volume.

The protocol’s second asset is MegaSerum (MSRM). 1 MRSM is created by locking 1,000,000 SRM. The main utility of MRSM is for nodes; each node must hold at least 10,000,000 SRM and 1 MRSM to participate. In addition, MRSM holders receive enhanced rewards when compared to the same quantity of “unlocked” SRM.

The token emission schedule is especially important to study. When the project launched in August 2020, 10% of the total supply (1 billion) was unlocked with the remaining 90% (9 billion) locked for a year. After the one-year lock-up expired, the other 9 billion SRM unlock linearly over 6 years until August 2027, resulting in a total of 10 billion SRM tokens in circulation.

Today, a few months into the vesting schedule, SRM has a total supply of 1.1 billion SRM (11% unlocked), but only 133 million SRM are actually in circulation. This means there are over 900 million SRM still held by team members, vested to early investors, locked in smart contracts, or otherwise out of circulation, in addition to the other 9 billion locked SRM. This amounts to only 1.3% of SRM’s future supply currently in circulation.

To see how this figure compares to the broader ecosystem, just look at the proportion of circulating Y2050 projected supplies of other DEXes: Curve (18.23%), Uniswap (41.66%), DODO (11.16%), dYdX (5.63%), 0x (84.55%), and Raydium (13.61%), to name a few. While it’s difficult to make a true apples-to-apples comparison since each of these protocols has very different tokenomics, SRM stands apart as being particularly low. This is somewhat concerning for current tokenholders: low liquidity can amplify market volatility and future token unlocks will dilute existing investors.

As a result of this low circulation proportion, the protocol’s fully-diluted valuation (FDV), which takes into account the large number of locked SRM on the sidelines, is around $75B. This would value Serum at more than the combined FDVs of Uniswap, Sushiswap, and Curve—the three largest DEXes—at current prices, despite having substantially lower transaction volume.

This has spurred a broader conversation in the Serum community around the project’s tokenomics, which has intensified in recent weeks. In particular, community members seem to be asking for greater clarity on the distribution of tokens (including VCs and other insiders), any financial agreements or investments into other projects, and the plan for decentralized governance moving forward as a DAO. The team has begun to address some of these concerns, but more answers will be necessary.

Looking Forward

When thinking about the future of Serum, coming up with specific projections is a fool’s errand. From a bigger-picture standpoint, however, there are two main questions to be resolved.

First, what is the outlook on the future of the Solana DeFi ecosystem?

The recent explosion of projects, uptick in usage, and general excitement around Solana should not be underestimated; the nascent blockchain has struck a balance with the blockchain trilemma that is attractive to both users and developers. Solana is not going away and, while an imminent “flippening” is unlikely, it is a worthy challenger to Ethereum and will continue to form an important part of the smart contract universe.

Using Ethereum’s growth as a baseline, Solana is still at the very beginning of the curve, having passed $5B in TVL only a few months ago. If DeFi on Solana continues on its current trajectory (and that of Ethereum), it could conceivably surpass $100B in TVL in less than six months.

Second, how much of the Solana DeFi ecosystem’s growth will be captured by Serum?

This is a far more difficult question to answer. It relies on a number of factors: continued innovation from the core team, the resolution of community criticism, and defensibility against new (and cross-chain) competitors, to name a few.

Over the past six months, Serum’s volume (and SRM’s token price) has more or less followed the growth of DeFi on Solana. While Serum’s volume is certainly more erratic, it seems to directly benefit from an expanding Solana ecosystem.

The bull case, then, is that as DeFi on Solana continues to flourish, Serum will serve as an essential part of liquidity infrastructure for the entire ecosystem, earning protocol fees that accrue to the SRM token. The protocol’s liquidity network effect is a strong moat that could cement Serum as an essential DeFi “lego block” for years to come. It is also a bet on order book DEXes continuing to chip away at the hegemony of AMMs; it’s not difficult to imagine decentralized order books comprising a multiple-billion-dollar market themselves.

The bear case, however, is that either (a) Serum will lose its market position as the dominant on-chain order book for Solana (and cross-chain) as new competitors enter, or (b) concerns around SRM’s token supply and distribution embroil the project and fail to deliver returns to investors.

Regardless of Serum’s future, it’s important not to forget the project’s groundbreaking journey. In around a year, the project has built among the first truly decentralized on-chain order books, been a key enabler of the entire Solana DeFi ecosystem, and has settled tens of billions of dollars in the process. Serum, by most standards, has been successful in delivering on its ambitious promises.

Today, Serum is preparing for the industry’s next leg of growth: a ballooning Solana ecosystem, novel DeFi innovations, and cross-chain interoperability. Whether Serum can remain the industry-leading “liquidity middleware” remains unclear. If they do, the opportunity is massive.

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