Current State of DeFi

As the landscape of decentralized finance matures, prediction markets have become a significant area of innovation. These markets utilize various paradigms for operation, each with its advantages and limitations. Currently, the most prevalent models for setting up new prediction markets are Automated Market Makers (AMMs) and Order Books, each catering to different aspects of market dynamics.

Automated Market Makers (AMMs)

AMMs represent a popular model in the DeFi space, primarily due to their fully on-chain and trustless nature, which aligns with the ethos of decentralization. They are particularly effective for kickstarting new markets due to their ability to facilitate trades without requiring a large number of active participants. However, a significant drawback for liquidity providers (LPs) in AMM-based markets is the risk of impermanent losses. These losses occur when the price of tokens inside the liquidity pool changes compared to their price when they were deposited, often resulting in a scenario where the losses outpace the fees earned by the LPs. This issue can dissuade potential LPs from participating, thereby stunting the growth and liquidity of these markets.

Order Books

Order book models allow users to trade in a peer-to-peer (P2P) fashion, which can be more efficient as they do not require intermediaries or liquidity providers, thus eliminating the risk of impermanent losses. However, these systems face significant challenges in the early stages of a prediction market's life. Low user engagement results in sparse order books, leading to low order matching rates which can severely impact market functionality and user experience. Adding a new market also becomes a significantly tough challenge. Additionally, many existing order book implementations rely on off-chain mechanisms for order matching to enhance performance and scalability, which introduces a level of trust and centralization, detracting from the decentralized nature of DeFi.