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Use empirical research to answer this question that has always puzzled users and developers in the DeFi world.
Written by: Cui Chen, working at HashKey Capital Research
Audit: Zou Chuanwei, Chief Economist of Wanxiang Blockchain
AMM (Automatic Market Maker) is currently the most popular trading model in the DeFi field. It is different from the order book matching method. AMM uses a fixed product method to convert tokens in the trading pool. Transactions can be automatically executed to ensure the flow of trading pairs. Sex.
AMM has two participants, the trader and the liquidity provider (LP). LP will first inject a certain amount of tokens into the pool to provide transaction liquidity, while earning transaction fees paid by traders. Generally, the AMM agreement will issue its own governance tokens and distribute them to LPs as rewards for participating in the community.
For liquidity providers , the act of providing liquidity to earn income is called liquidity mining, especially to obtain the project’s native governance tokens. This method is very common in DeFi. In this way, the project party distributes the native tokens to the real users of the community, that is, the most real stakeholders of the project. However, due to the existence of impermanent losses , LP participation in liquidity mining cannot guarantee stable income.
Whether the liquidity mining model can become a sustainable business model is a question that needs to be paid attention to in DeFi. This article analyzes the sustainability of liquid mining in AMM from the perspective of AMM traders and liquidity providers.
Motivation of traders
Compared with other trading methods, the main advantage of AMM comes from its complete decentralization . There are two specific manifestations: a transparent transaction method and an anti-censorship use method.
Different from centralized trading platforms, user funds are always stored in their own wallets during DeFi AMM transactions, and transactions are achieved through contract interaction, rather than traditional recharge and withdrawal methods, which can avoid fraud and fraud on centralized trading platforms. Theft and other issues. Anti-censorship is embodied in the anti-censorship of the user’s identity and the anti-censorship of the transaction pool. Users can conduct transactions without KYC , and the opening of the transaction pool does not need to be reviewed. A large number of initial stage tokens can be circulated by setting up a transaction pool. Therefore, users can participate in the early stage, or buy potential project tokens, and then obtain high returns .
AMM’s automatic trading is also one of its advantages. AMM can automatically exchange through a fixed product, which can ensure that the transaction is completed in time and has sufficient liquidity, even large transactions can be completed.
The exchange rate in the AMM transaction pool is passively changed . Only the transaction behavior can adjust the token exchange rate. The adjustment time interval is the block time of Ethereum. If the exchange rate under the chain changes, the exchange rate of the trading pool can only be adjusted to a normal level through the trader’s arbitrage behavior.
Therefore, in general, the motivation for traders to use AMM comes from transparent and decentralized trading methods, high returns from early projects, and arbitrage opportunities on and off the chain.
At present, the two well-known projects in AMM, Uniswap and Sushiswap , both have a handling fee of 0.3%, which is higher than that of a centralized trading platform, and an additional gas fee on the Ethereum chain has to be paid. Gas fees have been high recently, far exceeding transaction fees, but Uniswap and Sushiswap’s transaction volume still remains at the forefront of all cryptocurrency trading platforms. The benefit of rational traders in this process will definitely exceed the expenditures, indicating that even under high handling fees, traders’ demand for AMM has always existed. Therefore, from the perspective of traders, the motivation to use AMM is stable.
Motivation of liquidity providers
Liquidity provider’s income impact
The liquidity providers in AMM can be divided into two types, one is the project party that provides small currency trading channels, and the other is the participant of liquidity mining . Only the second case is discussed here. The motives of these LPs are very clear, they are just pursuing financial gains. The income comes from the transaction fees of traders and the project’s native governance tokens.
In fact, LP earnings will be affected by three factors: transaction volume, native governance tokens, and the market value of the liquidity pool.
Transaction fees are an important source of income for LPs, and this part of the income is entirely derived from the expenses of traders. Transaction volume and fee rate are indicators that affect transaction fees. Traders’ exchange transactions will be deducted according to the fee rate , and the deducted part will be directly left in the transaction pool. In the case of a fixed fee rate, the greater the transaction volume, the greater the commission fee.
Native governance token
The project will distribute native governance tokens to the liquidity pool as a reward, which becomes another source of income for LP. Factors affecting this part of income include the amount and price of the distributed native tokens. The allocation qualification and quantity of the trading pool are determined by community voting. The distribution of governance tokens is based on the transaction pool. No matter how the total amount of tokens in the transaction pool changes, the number of governance tokens allocated within a certain period of time is a certain amount.
Receiving native tokens is divided into two steps. First, LP deposits a corresponding proportion of tokens in the trading pool and obtains the certificate LP Token . For example, depositing in proportion to the ETH-USDT liquidity pool can obtain ETH-USDT LP Token. After that, the LP Token will be mortgaged, and the corresponding amount of governance tokens will be exchanged according to the individual’s overall proportion. LP’s share of the liquidity pool and the value of governance tokens will affect its returns.
Liquidity Pool Market Value
After depositing the corresponding token, the liquidity pool provider will obtain a certificate of LP Token, and then use this certificate to exchange for two tokens in the corresponding proportion when exiting. Then the market value of the overall liquidity pool will also affect the overall LP** **income.
There are two sources of fluctuations in the market value of the liquidity pool, one is the change in the composition of the liquidity pool , and the other is the price fluctuation of encrypted assets. But for liquidity providers, even if the initial principal is not recharged into the liquidity pool, it will change due to the fluctuation of the price of encrypted assets.
This article discusses the sustainability of liquidity mining, focusing on the impact of LPs due to the provision of liquidity. I will not discuss the price fluctuations of encrypted assets for the time being, and only focus on the impact of changes in the composition of the liquidity pool on LPs. It is impermanence loss.
When the exchange rate of the token changes, LP will always suffer impermanence losses , because LP has been passively acting contrary to the market. In the process of exchange rate changes, LP always passively sells tokens with rising exchange rates and buys tokens with falling exchange rates. Exchange rate changes are reflected in changes in the proportion of tokens in the pool. When calculating the impermanence loss, only the exchange rate changes at the two moments of LP recharge and token withdrawal need to be considered.
Liquidity provider’s income calculation
Transaction fees and governance tokens are the income of the liquidity pool, and impermanent losses are losses, so the income of the liquidity pool can be calculated based on these three items. The rate of return of each LP is equal to the rate of return of the liquidity pool. Obviously, if the handling fee and allocated governance tokens do not increase, the more tokens in the liquidity pool, the lower the overall rate of return will be.
Practice of AMM
Here we take the ETH-USDT trading pairs in Uniswap and Sushiswap as examples to measure the actual income of LP after providing liquidity.
Now Uniswap has stopped liquidity mining, LP will not have UNI allocation when providing liquidity, so Uniswap only needs to consider the handling fee and impermanent loss, and Sushiswap needs to consider the allocated amount and price of SUSHI. The following data is the 24-hour data from February 24th to February 25th.
Figure 1: Uniswap and Sushiswap ETH-USDT trading pair interface
Uniswap and Sushiswap’s ETH-USDT transaction pair interface displays the current exchange rate , quantity , total value and value of the transaction fee of the tokens in the pool. Therefore, we can calculate the initial proportion of the tokens and the impermanent loss tolerated based on the current number of tokens and exchange rate changes. The calculation takes into account the injection of fees in the pool.
Table 1: Uniswap and Sushiswap’s impermanent loss calculation/USD
The annualized rate of return of the LP can be calculated based on the impermanent loss, the amount of locked positions, the handling fee and the value of the distributed governance tokens.
Table 2: Uniswap and Sushiswap revenue calculation / USD
Among them, 77.3% of the annualized income of Sushiswap is derived from the distribution of SUSHI token income (calculated at the unit price of 15 US dollars on the day). After the unit price of SUSHI drops, this part of the income will decrease.
As can be seen from the above table, even if Uniswap stops distributing tokens to the liquidity pool, the annualized income of LP is still at a high level, which confirms the high transaction volume of the top AMM trading platform. On the day from February 24 to February 25, if the income is only the fee, the annualized rate of return of Sushiswap (17.0%) is much lower than that of Uniswap (60.0%), but the reward of governance tokens is added , Sushiswap surpassed Uniswap; at the same time, Sushiswap’s ETH-USDT pool lockup volume is higher than Uniswap. It can be seen that funds are biased towards projects with high yields. If Sushiswap’s lock-up volume continues to increase in the future, its annualized yield will decline under the condition of unchanged handling fees and governance token income.
The distribution of UNI and SUSHI is based on the results of project governance and is a dynamic process. If the total revenue and liquidity in the pool are not high, token mining can be used to give additional incentives . In the distribution of governance tokens, the total amount of tokens will be issued in a certain proportion every year after the distribution is completed.
The annualized return calculation in this section is based on the data within 24 hours. The volatility rate of ETH-USDT on this day is about 6%. If the fluctuation of ETH in other periods is higher than the fluctuation of this day, and the level of handling fee is lower than this day, the annualized rate of return of LP will decrease, and vice versa.
Figure 2: Comparison of Uniswap ETH-USDT trading pair liquidity and trading volume
Judging from the comparison of the liquidity and trading volume of the Uniswap ETH-USDT trading pair, the average liquidity has declined compared with the previous October or so, but the average trading volume has increased compared with October last year. If the impermanence loss is not considered, The income of LP is continuously increasing and very impressive. However, after October, the exchange rate of ETH to USDT has risen a lot, with the highest increase reaching 6 times. In this process, LP has suffered a lot of impermanent losses. If the exchange rate when LP withdraws from the pool is the same as when it is charged, then LP will not be affected by impermanent losses.
Finally, it should be noted that the rate of return in this article is calculated on the basis of the total amount of liquidity pools unchanged. If you want to calculate the rate of return of LP in a long-term dimension, you also need to consider the effect of LP deposits and withdrawals on the total amount of liquidity pools during the period. Impact.
Sustainability of liquid mining in AMM
For the AMM transaction method, the demand for arbitrage on and off the chain and the highly transparent and decentralized transaction method always exist, so the demand of traders has always existed. But for liquidity providers, they will have the incentive to participate only when they are profitable. According to the calculation method of the liquidity provider’s income, it is mainly related to the handling fee, the value of the original governance token and the gratuitous loss.
The impact of handling fees
The handling fee is related to the transaction volume and fee rate, and the user’s transaction volume demand comes from arbitrage and real transaction demand. If the currency price fluctuates greatly, the demand for short-term arbitrage will increase. The real transaction demand comes from the user’s preference for decentralized transactions and the invocation of other Defi applications. The Ethereum gas fee will also affect the user’s transaction preferences, because the Ethereum gas fee is generally also counted as the user’s handling fee.
The value of native governance tokens
The value of the native governance token directly affects the income of liquid mining , but its price fluctuates greatly, and it is difficult to determine an accurate value range . There are currently several indicators that can be used to determine the value range of governance tokens, including lock-up volume, transaction volume, and other functions.
The amount of lock-up can indirectly determine the power of governance tokens . Even if the power of governance does not mean the right to use the locked-up funds, the governance results will affect the amount of lock-up of the project. The locked-up amount represents the liquidity basis of the project. Generally, the higher the locked-up amount, the higher the value of project governance rights .
The amount of transaction volume represents the real usage of users, and transaction volume is directly related to LP’s income. Like the lock-up volume, the value of governance tokens cannot be directly linked to the transaction volume, but the transaction volume can reflect the valuation of the project. The higher the transaction volume, the higher the valuation of the project, so the increase in transaction volume and users often means an increase in the value of governance tokens.
Platform tokens issued by centralized trading platforms generally have multiple functions, such as voting on tokens, discounting transaction fees, and paying exchange public chain gas fees. These functions all endow the platform tokens with a certain value. Although AMM’s governance token will not have the same design as the platform currency of a centralized platform, it will gradually add other functions. For example, in Sushiswap, only 2.5% of the 3% handling fee charged to traders is allocated to the liquidity provider, and the remaining 0.5% is used to repurchase Sushi, adding the value of the handling fee to the governance token.
Impact of impermanence
For liquidity providers whose costs are two tokens, impermanence loss is the only loss they may suffer. According to the calculation method in this article, the impermanence loss is only related to the proportion of tokens in the LP recharge and withdrawal liquidity pool. If its token ratio is the same at these two time points, then LP will not suffer impermanence losses. Therefore, when the exchange rates of the two fluctuate within a certain range, LP can obtain fee income without suffering impermanence losses. If the exchange rate rises unilaterally, the LP’s impermanent loss may be higher than the gain.
Using call options or designing impermanent loss insurance is an attempt to control the scale of impermanent loss in the future.
Thinking and summarizing
The sustainability of AMM liquidity mining can be analyzed from the two perspectives of the participants, the trader and the liquidity provider. If the transaction process can benefit both parties, then liquidity mining can be regarded as sustainable . Traders pay for transaction fees and gas fees on the blockchain, and they get arbitrage profits, open and transparent security guarantees, and transactions that do not need to be reviewed.
For LP, although it has suffered impermanence losses, it has received transaction fees and possible project native governance token rewards. At present, the annualized rate of return of LP is still very high. If calculated according to the current fee income, LP participating in liquidity mining can obtain a high fee income. Token rewards are also a very important part. The number and time of token rewards in the trading pool are determined by platform governance, which is very flexible. The inflation model of liquidity tokens can allow the behavior of issuing tokens to continue, and at the same time, the project team will design some other ways to lock the token design function to add more value.
This article calculates the rate of return of legal currency based on the premise that the initial cost of LP is two tokens. If the initial cost of LP is obtained through borrowing, then the borrowing cost of LP and the change in the overall market value of the token need to be considered. If the value of the relevant token fluctuates, LP will be passively forced to be affected, because LP cannot adjust its position, and the recharge and withdrawal of LP require a lot of handling fees, so there are not many LPs that obtain the principal through borrowing for liquid mining Generally, LP owns two kinds of tokens for the purpose of currency-based financial management. In this case, LPs need to pay special attention to the impact of impermanent losses. When the rise or fall is too large, it may cause income to be difficult to compensate for impermanent losses.
In general, liquid mining in AMM is a sustainable business model. With the development of DeFi, the number of people using AMM will increase. DeFi is still in the development stage. Eventually, in a mature market, the rate of return of each AMM project will tend to be consistent and stable.