DFlow on Mainnet: The Open and Fair PFOF Standard

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Thesis

DFlow: A Protocol For Decentralized Order Flow Markets

Solving non-toxic order flow segmentation with tokenomic incentives

DFlow is the protocol powering the first decentralized order flow markets.


What Are Order Flow Markets?

Order flow is liquidity, i.e. unfilled bids and offers, generated by market participants, and is a useful asset that can be sold based on the value inherent to it; purchasers of order flow are generally institutional market makers who purchase it with the intention of using the liquidity to supplement their market making activities.

Order flow markets enable their participants to buy and sell order flow, and DFlow is the protocol powering the first decentralized order flow markets, allowing order flow to trade at free market rates.

The drivers of value-add to order flow are numerous but are primarily based on the non-toxicity of the order flow, a property that is influenced by the entities that generate the order flow and their motivations for trading. Consider three types of primary participants in markets: institutional makers, institutional takers, and retail traders. Each engages in trading activities but does so with very different methodologies and motivations.

Institutional makers are large balance sheet entities that provide liquidity through passive bids and offers. They trade when their passive liquidity is hit by takers, and they often trade for free or earn rebates on exchanges.

Institutional takers are large balance sheet entities that buy and sell tokens by taking passive bids and offers. They are one of the counterparties to institutional makers, and they pay exchange fees to trade. See the Serum Fee Schedule for a generalizable example of maker and taker rates.

Retail traders participate in markets based on their relative utility preferences between the assets they trade; for example, they swap token X for token Y because token Y has greater utility to them, where the greater utility is derived from one of many different reasons. Perhaps they need token Y to participate in a different DeFi ecosystem, or they believe token Y will appreciate in value over a long time period, or they believe in the team behind token Y.

These reasons for trading make retail trading activity benign, and therefore retail order flow is considered non-toxic. In contrast to this, institutional takers typically intentionally submit orders to extract arbitrage profits from market makers, making their order flow toxic. Order flow toxicity negatively affects market makers due to the risk of adverse selection. Market makers, who may be unaware that they are providing liquidity at a loss, seek non-toxic order flow.

Therefore, institutional makers prefer to trade with retail traders over institutional takers because retail traders' motivations for trading reduce the risk of adverse selection to the institutional makers. And therein lies a capital inefficiency: because institutional makers prefer to trade with retail traders, they're willing to pay a premium on orders to fill retail traders’ orders but have no practical way to do so due to a lack of order flow segmentation.


Order Flow Segmentation

Order flow segmentation, the separation of non-toxic and toxic order flow, is an important tool in promoting healthy markets because it increases market efficiencies; institutional market makers are willing to pay a premium for non-toxic order flow, and sources of non-toxic order flow (e.g. wallets, browser-based swappers, or brokerages) are able to earn that premium to help reduce their costs. They can choose to pass this premium on to traders, which incentivizes acquisition and retention. However, without effective order flow segmentation, the order flow premium cannot be extracted and the sources of non-toxic order flow, despite having non-toxic order flow, cannot monetize that asset.

DFlow fixes this.

The DFlow protocol has a dual purpose:

  • Incentivize, by a combination of tokenomics and broad system design, non-toxic order flow to enter the system and be routed to market makers, while repelling toxic order flow
  • Mandate fairness and transparency in trade prices for non-toxic order flow by market makers

In doing the above, DFlow unlocks capital efficiencies that enable non-toxic order flow sources to fairly earn from their order flow and institutional market makers to deploy novel DeFi trading strategies.

The DFlow protocol mandates transparency and fairness in trade prices


Order Flow Segmentation Using Tokenomic Incentives

In decentralized markets today, there is a pronounced lack of order flow segmentation. Decentralized RFQ systems and MEV approximate order flow markets, but MEV doesn't address the privacy of order flow, and neither RFQ nor MEV address order flow segmentation nor the toxicity of the order flow through their systems.

Traditional markets have various centralized ways of addressing order flow segmentation, such as exclusive legal contracts between brokerages and trading firms (i.e. payment for order flow), but crypto provides a better design space via trustless guarantees and programmatic economic incentives that can align the interests of all market participants.

The DFlow protocol has hard-coded programmatic and immutable incentive structures to reliably segment decentralized order flow in a way that’s only possible only in this rich design space. The protocol's built-in tokenomic incentives encourage retail traders to route their (non-toxic) order flow through the system, while strongly discouraging institutional takers from sending their toxic order flow altogether.

Additionally, the protocol explicitly partners with known sources of non-toxic order flow, such as wallets, DEX aggregators, and browser-based swappers, to ingest non-toxic order flow and reward users with the best fill prices and attractive trader rebates. Not only does this disintermediation of exchanges help retail traders avoid expensive exchange fees, but rebates are also credited where previously taker fees would be debited; in this way, the DFlow protocol helps retail traders monetize the non-toxicity of their order flow.


Order Flow Contracts & Auctions

One of the protocol’s major innovations is the introduction of a new financial primitive: the Order Flow Contract.

The Order Flow Contract is a programmatic agreement that is purchasable, but not resellable, and grants the holder immediate physical delivery of non-toxic order flow. These contracts are non-fungible due to tranching of notional sizes, order flow batch sizes, order types, and an element of time.

Order Flow Contracts are sold repeatedly over time via competitive decentralized auctions in which institutional market makers bid on a contract delivering order flow at a specific point in time. The purchase price of these contracts is distributed back to the order flow source as a rebate, aligning the interests of the maker and taker.


Algorithmically Enforced Fairness

Fairness in fill prices is programmatically enforced in the protocol. As market makers fill order flow, their fill prices must be within a governable threshold of the best available absolute price, as currently determined today by Pyth, where the threshold is a function of market volatility and liquidity.

Governing agencies in traditional markets require best execution but retail traders have very little transparency into the quality of their order flow execution. In decentralized markets, the DFlow protocol provably provides best execution, enforced on-chain by code.

Trades made by retail traders are always filled at the best available prices, enforced on-chain


Protocol Composability

Protocol composability will be one of the key drivers of flow volume growth in DFlow: the protocol will allow other protocols to use DFlow as a black-box of market-maker-powered liquidity by routing orders to DFlow and receiving fills and premium rebates in return. By doing this, DFlow can be thought of as programmatic, on-demand, best-execution liquidity.

This native composability leads to a combinatorial explosion of use-cases, ranging from structured product order flow to liquidation management.


Open Source Tooling

In addition to an open source and audited protocol, open source tooling will be released at Devnet and beyond to make auction participation, order flow routing, submitting and filling orders well-documented and simple to configure.


Start Building

DFlow protocol is in closed alpha today but we’ll be launching soon! If you are a market maker interested in novel DeFi market making strategies, get in touch. We’re starting conversations now. Similarly, if you manage a source of non-toxic order flow and you’re interested in routing to the DFlow market makers to earn premiums, or manage a protocol/DAO interested in accessing the DFlow liquidity engine for your own DeFi products, join our Discord or contact us on Twitter.