Faced with defects such as slippage and impermanent losses of automated market makers, the Chinese DeFi project DODO tried to solve it through the “active market maker” algorithm.
Written by: Liam Kelly, Ashwath Balakrishnan, at Crypto Briefing
Summary
- DEX is still full of various defects, including slippage and impermanence
- The Chinese cryptocurrency project DODO hopes to solve some of these shortcomings through its novel “active market maker” algorithm.
- This platform is nascent and has not been tested by time like the existing Uniswap and Curve.
Although traders can choose many DEXs currently, few DEXs like Uniswap dominate. The unicorn encryption platform is still far from perfect.
DODO Exchange is a new force in the DeFi field, hoping to grab market share on the basis of improving Uniswap’s defects. how to improve?
Through a novel market-making algorithm, improve the liquidity of funds, and try to eliminate impermanent losses.
Start with DEX first
The main reference object in this article is Uniswap. Other related DEXs include Bancor, Curve, Kyber and Balancer.
The popular DeFi trading platform Uniswap People have a basic understanding of automatic market making AMM, its inadequate design, impermanence, slippage, and the role of arbitrageurs in DeFi. DODO and its competitors are using similar concepts to redesign their portfolio.
AMM’s token pricing mechanism is different from centralized exchanges. AMM is not looking for a counterparty to buy and sell assets and determine the price accordingly. The counterparty is replaced by a liquidity pool of tokens locked in a smart contract. Unlike centralized exchanges, the liquidity of these fund pools is provided by users.
DEX incentivizes these users to return by providing liquidity. Uniswap’s current transaction fee level is 0.30%, and the fee charged is distributed to all liquidity providers LP to help maintain the platform.
Platforms such as Uniswap also have different pricing methods for the assets being traded. For the sake of accuracy, it should be said that there are many types of AMM. Uniswap uses a pricing method called “constant function market maker”. DODO uses another method called “active market maker”.
Uniswap’s AMM design is named after the constant function of its price algorithm. Uniswap uses the equation x * y = k to replace the method of supply and demand determining asset prices, which is very common in many order book-based exchanges.
“X” and “Y” represent the supply of specific tokens in the liquidity pool in the Uniswap agreement. As traders buy and sell tokens from this pool of funds (ie buying and selling “X” and/or “Y”), the price of each token will change, and the product “K” of the two will remain unchanged.
This design is perhaps the most popular design in the DeFi field at present, and has helped inspire a series of new ideas in the field of decentralized transactions. And Uniswap makes it easy for anyone to provide liquidity with any ERC-20 token of their choice. There is no consortium or regulatory gatekeeper to decide which tokens are available for trading.
Unfortunately, this design is not flawless, just give a few examples: slippage and impermanence are the flaws of this design.
Demystifying the flaws in the existing DEX design
Slippage refers to the price difference between the price at which an asset is purchased or sold and the price at which it is actually executed. During periods of high market volatility, slippage may be severe due to large price fluctuations between transaction and execution. In cryptocurrency transactions, this problem is further exacerbated due to the inherent slow execution time of blockchain technology.
In addition to high price volatility and slow execution time, a market with insufficient liquidity is also very likely to have slippage. If the size of the transaction is large enough, and at the same time the asset liquidity in the DEX is insufficient, the price of your favorite token may immediately rise or fall.
The Uniswap agreement has managed to minimize the slippage of small transactions, but large transactions may incur high fees for traders. The DEX provides traders with a variety of tools and settings to better measure slippage.
“Expert Mode” allows traders to activate high slippage trading. Source: Uniswap
In short, one can see the trade-offs Uniswap has made. The high slippage of large transactions in Uniswap stranded giant whale investors in exchange for providing liquidity forever in illiquid markets (such as certain tokens with low interest).
The second problem faced by Uniswap and several other DEXs is slightly more complicated, that is, impermanence loss.
The price of assets in the Uniswap agreement is determined by the above internal function algorithm, instead of real-time price information provided by third-party oracles such as Chainlink. This algorithm may bring prices that are very different from other platforms.
For example, if the price of LINK rises by 15% on a centralized exchange, Uniswap may not realize this appreciation immediately, creating a time window where arbitrageurs can buy LINK at a lower price on Uniswap and then other Places are sold at a price increase of 15%.
Therefore, arbitrage trading is a common situation in DEX, because arbitrage traders flock to sell assets at high prices or buy cheap assets for profit. Arbitrage is not necessarily a negative issue, but it will cause trouble for the LP in Uniswap. Due to arbitrage activities, these LPs in Uniswap may suffer heavy losses, specifically impermanence losses.
LP must pledge its assets in Uniswap in order to earn returns. However, in the course of large price fluctuations and active arbitrage, the amount of pledged assets will change to keep the “K” unchanged.
Therefore, if you just put LINK in your wallet and enjoy a 15% price increase, but if you pledge LINK to provide liquidity for Uniswap, you may find that the LINK you pledged in the Uniswap agreement has been bought by arbitrage transactions .
In order to have a deeper understanding of the nature of impermanence loss, readers are advised to read this article .
What is the DODO exchange?
After understanding the DEX knowledge summarized in the previous article, it is time to reveal the secret of DODO.
The DODO platform also provides digital asset trading on the chain, but claims to have order execution capabilities on par with centralized trading platforms. LPs and arbitrageurs also play a vital role in this ecosystem, and the DODO team claims that they actually eliminate impermanence losses.
In addition, although not introduced before, the LP in DODO does not need to provide the two tokens of the trading pair. LP can use any single asset to increase the liquidity of the fund pool and start earning income.
DODO implements these solutions partly because of changes in its market-making algorithm (called “active market maker” PMM). DODO does not use Uniswap’s x * y = k function equation, but uses:
The “i” represents the market price of an asset, and “R” represents the risk factor. Understanding “R” is the key to understanding how DODO can incentivize high liquidity at an accurate price.
In view of the partnership with Chainlink in August 2020, DODO uses Chainlink’s real-time quotation stream to establish “i”. This data creates a benchmark, and the DODO algorithm can avoid the huge price deviations that sometimes occur in Uniswap. With the accumulation of specific asset capital and the increase in liquidity, the “R” function will also change.
DODO explained the result :
“According to the liquidity in the fund pool, the PMM algorithm adjusts the value of R in real time to fine-tune the market price P in DODO to maximize the utilization of funds.”
As a result, the liquidity of a specific asset is transferred to the price of that asset based on Chainlink’s data.
Compared with Uniswap, DODO provides liquidity based on market prices. As the market price changes, the liquidity gathered around that price also changes. Source: DODO
The DODO model can also be seen as creating a real-time market flow as a benchmark for the system’s price. But this model does place a high level of trust in Chainlink’s data.
If the Chainlink node fails to update correctly or encounters an attack, DODO may call the wrong price information. This is undoubtedly causing serious losses to LP.
The team and investors behind DODO
Experience is very important, especially for DeFi projects that build infrastructure for alternative financial systems. The three co-founders of DODO are all veterans in the blockchain industry.
Mingda Lei is the co-founder of DODO and the architect of the protocol’s active market maker algorithm. Lei was a core developer of DDEX , a DeFi leveraged trading platform, and has a PhD from Peking University.
Qi Wang is a software developer who created DOS Network, a layer 2 oracle service in China. Before entering the encryption field, Wang worked as a software developer in companies such as Oracle and Pure Storage.
The third co-founder is Diane Dai. She runs the WeChat public account DeFi Labs, and a series of other channels.
Despite fierce competition in the AMM field, DODO has recently completed a seed round of financing from a number of well-known institutions, including Framework Ventures, DeFiance Capital, Spencer Noon (DTC Capital), Jason Choi (Spartan Group), Bobby Ong (CoinGecko) and Robert Leshner (Compound).
The heavyweight investors of DODO can bring appropriate expertise and network to the project, which is very helpful to the growth of the project. Especially Framework Ventures is known for bringing synergy between its investment projects, and its investment projects also include Chainlink, Aave and Synthetix.
The road to future success
The impermanence losses in Uniswap often become permanent losses. The 50-50 AMM discourages the giant whale, because larger transactions will cause high slippage. The cumulative effect is that new forces such as DODO are more like a move towards the right development.
DODO uses price oracles instead of simply balancing asset balances around constant function formulas, which allows AMM to provide traders and LPs with better trading conditions. Traders can obtain liquidity with better slippage than Uniswap. LP only needs to deposit a token to obtain income, which may also reduce the tragedy of impermanence.
One problem that the outside world is worried about is that if the DODO transaction volume is insufficient, LP will still face losses. If the trader takes advantage of liquidity, but the total fee earned by the LP is lower, then the end result is a loss. In order for LP to obtain stable profits from DODO’s market making, the transaction volume needs to increase continuously.
The agreement is still in its infancy, so compared to ensuring the normal operation of the product, there may be less consideration for transaction volume. If everything goes well, DODO can have a real impact on the liquidity of other AMMs.
The combination of automation of raising liquidity and order book exchange-style pricing and liquidity mechanisms may become an effective combination and become the best iterative product of AMM.
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