Uniswap has achieved the democratization of liquidity supply, and the new generation of AMM needs to help users better manage risks.
Original title: ” Where will the next generation of automated market makers in DeFi develop? 》
Written by: Chris Tham
This article is authorized to reprint from LongHash to Chain Wen
Automated market makers (AMM) have played a huge role in promoting DeFi and the democratization of liquidity supply, but they also have significant limitations. We need a new round of innovation to help mainstream users better manage risks and continue to participate in this change.
The evolution of the exchange
For most people, the first entry into the crypto world is often a centralized exchange such as Coinbase or Binance. Considering the sufficient liquidity, ease of use, and people’s familiarity with the classic order book mechanism of such exchanges, their popularity is easy to understand.
However, in the blockchain/encrypted world where decentralization is the priority, it is always awkward to rely entirely on a centralized exchange (CEX), especially when users’ funds are managed by CEX, and the assets available for trading are also owned by them. Decided.
Fortunately, decentralized exchanges (DEX) developed on Ethereum followed, such as 0x and DDEX, which provided non-custodial funds and smart contracts that could be reviewed. However, these DEXs still use the same order book model as CEX. In addition to worse UX/UI, they often suffer from severe lack of fluidity.
In the world of Web 3, DeFi is the engine for the democratization of financial services. If you have to rely on mechanisms from the “traditional world” at this time, it would be too untimely. This requires us to fundamentally rethink exchanges and liquidity.
The emergence of automated market makers
Led by Uniswap, Automated Market Makers (AMM) were introduced into the crypto world and soon became a typical representative of DEX, bringing liquidity to DeFi. In essence, an AMM exchange no longer relies on the order book model, but forms a pool of liquidity provided by others, and makes market according to a certainty function. Traders can get better liquidity, while ordinary users can get a profit from transaction fees as long as they use idle assets to provide liquidity.
Combined with the incentives provided by liquidity mining, AMM has experienced explosive growth because now liquidity can be “crowded” and the market making process has been democratized. In September 2020 alone, Uniswap’s transaction volume reached 15.4 billion U.S. dollars, almost $2 billion higher than Coinbase’s monthly transaction volume. At present, more than 93% of the share of DEX belongs to the AMM exchange. This model has proved with strong facts that it is an innovation that promotes decentralized transactions to the public.
But AMM is not a perfect solution in the strict sense. It does have some limitations, such as low capital utilization, additional risk exposure, and the issue of impermanent losses that is widely discussed. Liquidity providers (LP) have realized that market making is risky, and impermanent losses may occur. The reason for this “loss” is that LPs only need to store their assets in their wallets to obtain higher value.
The core of DeFi has always been a simple and straightforward pursuit of efficiency and profitability. Whether it is providing loans on a decentralized lending platform or providing on-chain liquidity, it is all about making capital never idle, but continuous Constantly put into use.
Although AMM itself has helped to democratize liquidity supply, the current model still needs further innovation to better fit the spirit of DeFi.
Next-generation liquidity supply solution
As the rapid innovation in the DeFi field has become the norm, alternatives to the AMM model soon emerged, which can better bridge the shortcomings of liquidity supply. For example, projects like DODO, COFiX, and Bancor are providing new and innovative solutions to solve existing problems.
Problem 1: Low capital utilization
One of AMM’s current main problems is the allocation of liquidity provided by LPs. For example, Uniswap uniformly allocates funds within the entire price range, which means that only funds allocated near the market price can be used effectively, while the rest of the funds are idle. This leads to high slippage and low capital efficiency.
In this case, the market maker algorithm must be more “smart”, more like a human market maker in CEX, able to continuously adjust their pending orders according to changes in market prices.
The next-generation solution for liquidity provided by DODO—the Proactive Market Maker (PMM) algorithm—is a good example. Unlike the AMM model, PMM uses a price oracle machine and plans to simulate human market making by aggregating liquidity near the market price.
Due to the flat curve of PMM, traders will be able to benefit from lower slippage. In addition, even if the market price changes, PMM will actively adjust the price curve to ensure that there is still sufficient liquidity. In this way, it is ensured that the capital utilization rate can be maintained at a high level, even with only one-tenth of the liquidity , it can also provide a slippage equivalent to Uniswap.
In the DeFi world, liquidity is as precious as oil. Everyone is competing for LP’s assets through various incentive plans. A decisive advantage of liquidity supply solutions is their capital utilization . Only those models that can provide traders with competitive liquidity and low slippage even without locking up a large amount of assets can ensure long-term success after the end of the liquidity mining incentive plan.
Question 2: Additional risk exposure
Another obstacle encountered by the vast majority of retail investors in terms of liquidity supply is that since Uniswap and other AMMs require the supply ratio of the two assets to be maintained at 50/50, they need to bear additional risks. And they are often unwilling to take this risk.
For example, if a user happens to have $100 worth of LINK tokens idle in their wallet and is considering depositing it in Uniswap to make a small profit from the accumulated transaction fees, he/she must deposit the value again Another asset of $100, such as ETH. This will lead to additional risk exposure, because the value of the user’s assets will now be affected by ETH price fluctuations.
However, an alternative to AMM has been developed that allows users to deposit only one asset, so that there is only a single risk exposure. This can be achieved in several ways.
Take LINK/USDC as an example. In DODO’s PMM, two assets of a trading pair each have a separate pool, resulting in two parts on the price curve, the buyer and the seller, in the two pools. The number of respective tokens is determined. This is the opposite of the single, larger 50/50 pool in Uniswap’s AMM. In this way, LPs only need to deposit assets according to the degree of risk they can accept, instead of buying unnecessary assets just for market making.
Other AMM alternatives to solve this problem include CoFiX, where you can deposit a single asset of any amount. However, this approach is inherently risky, because LP’s assets may depreciate due to the constant changes in the liquidity pool ratio, so LP is encouraged to adopt hedging plans. By mirroring the changes in the liquidity pool ratio in another market, users will be able to effectively hedge their positions, thereby offsetting negative fluctuations and locking in the profits obtained through market making.
Although the mechanism that requires users to deposit two assets to balance the liquidity pool has achieved the desired effect so far, as more retail investors enter the field, this approach will be difficult to continue to achieve the desired results. Therefore, for most liquidity supply solutions, ensuring a single asset risk exposure will become a basic requirement.
Question 3: impermanence loss
When LP realized that they only needed to hold assets without providing liquidity to AMM to make more money, they learned the concept of impermanence for the first time. Although there have been many articles on this topic extensively, but in essence, simple AMM is too simple in design.
AMMs like Uniswap are based on the “Constant Product Market Maker (CPMM) Model”, which calculates asset prices and balances the liquidity pool ratio according to the equation x*y=k. This is because Uniswap itself cannot understand the true equilibrium market price of an asset. Therefore, when the price on Uniswap is different from the external market price, it requires arbitrageurs to immediately enter the market to purchase the asset at a discount to rebalance the liquidity pool in use. . But for LPs, this essentially means that because AMM cannot perform its duties, they need to pay arbitrageurs to advance the price discovery and verification process.
However, there are several solutions to this problem, and these solutions usually use a decentralized oracle to minimize the impermanent loss that LP suffers.
Take CoFiX as an example. In theory, there is no impermanence loss because there is no arbitrage at the beginning. On the contrary, CoFiX uses the Nest protocol as an oracle to provide balanced market prices for its assets, while adding a slight premium to the market quotation, thereby pricing the calculable risk in each transaction and compensating for the risk taken by the LP. However, this solution can only help LPs effectively lock in their profits when combined with the hedging plan mentioned above.
DODO’s PMM uses Chainlink for decentralized price feeding, instead of the CPMM formula for price discovery. However, there is still the problem of changes in the proportion of the liquidity pool, and LP cannot propose the same number of tokens as deposited. Therefore, in this case, DODO encourages arbitrage trading through their PMM. PMM will make slight adjustments based on market prices to ensure that there is enough profit to encourage arbitrageurs to enter and rebalance the liquidity pool.
Another alternative to reduce impermanent losses comes from Bancor, which essentially introduces insurance to ensure that LPs can get back at least 100% of their initial capital and all accrued expenses. This is achieved through the flexible supply of BNT, which allows new BNT tokens to be minted on demand. At the same time, its feasibility also requires that the long-term cumulative benefits obtained through market making are greater than the impermanent losses suffered by the liquidity pool. The details of the mechanism can be found in this link.
Towards the future together
A key summary of the above-mentioned various options is: Although the supply of liquidity has been democratized, market making is not for everyone.
There is no free lunch in the world, and there are often complex risks, so individual LPs must decide for themselves whether they are willing to take risks. As liquidity mining rewards begin to decrease, what we may see is that retail LPs will no longer have so much motivation to contribute to liquidity, which in turn will affect the liquidity and performance of DEX.
There are several possible ways to expand in the future.
The first is the increase of professional market makers in DEX, who are willing to bring their liquidity to DeFi, because there are obviously profit opportunities. To do this, they need to have more freedom, both in terms of forming their own parameters or in their own capital pools.
The second is to allow users to manage their risks in a more innovative and effective (but preferably simpler) way. This is a core theme of DeFi, and it is also vital to DEX. The goal should be to maintain the current low entry barriers for LPs, while at the same time reducing unnecessary complex risks through insurance, risk tokenization, and even a set of supporting tools.
From this perspective, the optimal solution may be the one currently being studied by DODO, that is, professional market makers are increasingly entering DEX, allowing them to customize their own on-chain market-making strategies, thereby incentivizing them to flow Sex transfer over. In the future, retail LPs can also follow the same strategy to further reduce the complexity of liquidity supply.
In this case, traders can still enjoy the same depth of liquidity as CEX and at the same time enjoy the inherent advantages of DEX, such as no custody of funds, and no need for permission to increase support for new assets. At the same time, as long as individual LPs are willing to understand and take risks, they can still continue to provide liquidity and get a share of their platform, but ideally there will be innovation to help manage the above risks.
The world of DeFi is wild and imaginative. It is a brand new playground. Here, innovation is given ample room for it to thrive, or fail severely. The growth of DEX and AMM that we are currently seeing is part of it, and there is no doubt that it will continue to play a key role in driving DeFi’s mission to democratize financial access and services. But there are more possibilities to look forward to.
Get ready to go, the journey has just begun.
This article was originally created by LongHash Ventures and first published on Medium. LongHash Ventures is one of DODO’s investors.
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