By Wolfgang Rückerl, Co-Founder and CEO of Istari Vision and Entity.global
Automated Market Makers (AMMs) have unlocked decentralized finance (DeFi) liquidity and liquidity in general. Before 2019, people had to go through exchanges and list their tokens to provide liquidity, so the rise in this type of exchange increased access to seamless trading without gatekeepers. Without AMMs, DeFi users would have to rely on centralized or decentralized exchanges that use an order book model, like Serum on Solana, or Idex on Ethereum.
AMM innovations do more with less
It’s still too early to say whether there are niches when it comes to AMMs – decentralized exchanges (DEX) that use a pricing algorithm to price two assets – but one differentiator is the way these protocols are providing liquidity. UniSwap is a leading innovator in this space, and as a consequence, it’s the largest AMM. With UniSwap’s second version (v2), liquidity was everywhere and at every price point, meaning the potential of the liquidity was wasted.
But the exchange’s third version (v3) introduced the concept of concentrated liquidity, where liquidity providers will still place two tokens of the same weight in the protocol, but now they can specify a price range where their liquidity will be deployed to. For example, with Ethereum tokens and USDT, whenever the price goes out of that range, the liquidity will no longer be active and traders will no longer be trading against it, so the investor won’t lose any fees for the liquidity they provided. This mechanism provides more liquidity, less slippage, and less impermanent loss.
Tweaking the parameters and trends
We’re seeing more protocols tweaking their models to align with what UniSwap is doing. There are AMMs created for stablecoins, geared primarily toward performing stable swaps. Here, the liquidity is concentrated even more because it’s used to swap between, for example, USDC and USDT, where there is very little price variation.
Stableswaps are quite niche in their approach and tweak one parameter, so it’s highly efficient for a certain type of token. On Curve StableSwap, for instance, you cannot trade other tokens except for Stablecoins or closely pegged tokens, otherwise, it might not be that efficient when performing the swap. These stable swap optimizations are also able to swap between two assets that have an identical price – for instance, two wrapped bitcoin (BTC) assets, both of which are pegged to the BTC price.
Bots frontrunning the placed orders
When using AMMs, the swap may experience delays based on the blockchain’s confirmation times. This runs the risk of users being exploited by bots as this process front runs an investor’s order – they make a small profit by buying the asset before you and selling it back to you at a higher price. These small differences add up over time, and users lose value. To remove the potential for this, there are exchanges like Integral that are using time stamps. So, a user will send an order and they will know at exactly what time an order will be executed. Integral will also batch orders together and execute all of them in the order that they were sent.
On the one hand, because the exchange respects the order, the protocol ensures less slippage, doesn’t allow bots to front-run users, and decreases the chance of loss for people that want to trade large amounts. On the other hand, it’s less trustworthy, because users have to trust the protocol to send the orders in the same manner they were received and not be exploited.
Reshuffling the liquidity
Concentrated liquidity provisioning is not for everyone, because users have to move their liquidity around, otherwise, it won’t produce anything, and it will become useless. There are sophisticated players with large pools of assets who can afford to move their liquidity around frequently, and these players are putting very small price ranges into play and receiving a lot of fees. In other words, the liquidity is used better, and they constantly pull out their liquidity and put it back in depending on whether the price is moving up or down.
Average users cannot do this due to the high gas fees. Users have to make a transaction every time they reshuffle their liquidity, which eats into their profits. As a result, everyday users cannot provide liquidity as efficiently compared to others, whereas with earlier models, everyone was at the same table and had a fair share of the fees. On the other side of the coin, liquidity is much better at a higher price range. More liquidity means less slippage and less loss for the liquidity providers.
The lack of incentives is also a downside. Due to the impermanent loss, being a liquidity provider isn’t that worthwhile. Some experimental models try to make the experience more fruitful, but the problem is that they’re shifting the impermanent loss from the liquidity providers to the users and other involved parties. For example, Bancor tried to cover the impermanent loss of their liquidity providers with their own token and it was a fiasco. Due to the bear market, the Bancor token was offered in large quantities, and the protocol minted a lot of it. In the end, this destroyed the Bancor token value and the price fell drastically.
The road to improving AMMs
Many AMMs are simple on the interface level, but very complex in the background. In a sense, they behave like traditional finance, where you send your money to the bank and you’re unaware of how the bank is using it to produce a return or interest. The interface of AMMs tries to explain what goes on behind closed doors, but it’s too complicated and it confuses people. Explaining the automatic swap is simple, but on the liquidity side, it’s a confusing journey. For example, if the price of one of the two tokens moves in one direction with 5%, what is the new allocation in your liquidity provider (LP) token or what is your impermanent loss in case you are exiting the LP token at that moment? Very few AMMs are able to answer these questions within the UX, and people have to use another tool to see how their liquidity is performing and what they’re getting in terms of rewards.
In terms of making the experience cheaper for users, there are two options. Either AMMs can send orders in batches, as previously mentioned, so everyone will share the fees for that bundle, making it cheaper. Using alternative layer ones that have improvements on the smart contract level for different operations – such as swaps – is another approach that’s highly efficient and consumes less gas. Alternatively, some blockchains do have specific optimizations for decentralized finance (DeFi) and it’s especially helpful if AMMs deploy there.
Better protection and 100% transparency into the liquidity already places AMMs as the forerunner to centralized exchanges. The next generation of AMMs should improve key functionality and integrate tools needed by retail and institutional traders – such as liquidity performance and reward calculators – if they aim to surpass centralized exchanges in daily trading volume. AMMs that recognize the importance of the level of dedication of participants on a blockchain will be unstoppable.
About the author:
Wolfgang Rückerl is the Co-Founder and CEO of Istari Vision and Entity.global. He has also spearheaded the development of the Entity Launchpad, which launches innovative Web3 projects and includes complementary tools for reward strategies, investment analytics, and crypto taxation compliance. Wolfgang prides himself on being an innovator and blockchain instructor, as well as a mentor for ascendant Web3 companies building their product or service on the technology stack of the MultiversX blockchain (formerly Elrond). Prior to co-founding Entity and Istari Vision, Wolfgang worked in the industry of ethical AI and data privacy at Oosto (formerly Anyvision).
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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