DeFi Observation: If the bear market comes, will AMM and liquidity mining become unpopular?

Wu said author | Wu Shang

Editor of this issue | Colin Wu

In this round of bull market, the combination of AMM and liquidity mining has set off a wave of DeFi, and various innovations have emerged in an endless stream. But we must also see that its essence requires new tokens from liquidity mining to subsidize impermanent losses.

At present, some industry opinions predict that as the popularization of vaccines leads to monetary policy adjustments, the bear market may come as early as autumn. Then, will AMM and liquidity mining, which support the DeFi craze, continue?

AMM (Automated Market Maker), as the mainstream model of DEX, is popular because of its decentralization and the provision of "yield farming". However, its design itself has many defects compared to the order book model used by traditional exchanges.

For the market maker strategy in traditional exchanges, an excellent market making strategy needs to meet two points: 1. It can complete a sufficient amount of transactions. 2. It can avoid inventory risk to the greatest extent, that is, the impermanent loss in AMM.

The current market-making models of Uniswap and Sushiswap are flawed because Uniswap does not take advantage of the high volatility of crypto assets to earn price differences like traditional market makers, and requires the intervention of arbitrageurs to make its prices consistent with centralized exchanges.

This design is more for the convenience of users to trade, but it loses the profits of LP (liquidity providers). Especially after deducting the liquidity mining rewards, if only relying on earning handling fees, the income of most AMMs is very terrifying compared to the impermanent loss in the bear market.

Just like Uniswap has cancelled the liquidity mining rewards, other automated market makers like Sushiswap cannot always compensate LPs for impermanent losses through liquidity mining. The impact of canceling liquidity mining may not be obvious in a bull market, because the risk of participating in market making is relatively small in a bull market. However, in a bear market, the income from handling fees will inevitably decrease, and impermanent losses increase exponentially in a bear market, and LPs have many reasons to withdraw liquidity.

(In a bull market, even if the LP's coins increase fivefold, they only lose 25% compared to not participating in the AMM; but in a bear market, the LP's losses increase exponentially)

For ordinary DeFi users like me, if you want to know the sustainability of being an LP in AMM, there are two questions that need to be answered: 1. If there is no liquidity mining, can we still generate enough income? 2. Compared with AMM, is the market making strategy of traditional market makers better?

In essence, liquidity mining is an unsustainable reward that can only compensate LP's impermanent loss in the short to medium term. For LP, the only sustainable income comes from the fees generated by users using DEX. However, the dilemma of AMM is that if AMM stops liquidity mining rewards, it will easily lose TVL (total locked value) or be attacked by vampires.

As a leading DEX, although Uniswap has cancelled the liquidity mining rewards, it is still profitable to earn fees alone. APY Vision shows that its average fee in the past 30 days is as high as 53%. But this does not mean that all AMMs are like this. In fact, even Uniswap lost a lot of liquidity in the short term after suspending liquidity mining rewards in November 2020. Not to mention that it was attacked by sushiswap in August last year. In the case of sushiswap, because of its lower trading volume, its average income from fees in 30 days is only about 15%.

Source: APY Vision

Although Uniswap can currently earn enough profit just from transaction fees, once it enters a bear market, transaction fees will decrease, and as impermanent loss increases exponentially, AMM's LP has no reason not to withdraw liquidity.

The strategies of traditional market makers are completely different from the logic of automated market makers such as Uniswap. For traditional market makers such as Citidial and Jump Trading, their income mainly comes from earning price differences by “buying low and selling high” on assets, and traditional market makers do not earn most of the transaction fees like LPs of automated market makers when completing transactions, and may even have to pay transaction fees.

Therefore, they care a lot about managing "inventory risk". For example, when making a market for BTC/USDT, like the LP in the automated market maker, the traditional market maker will also prepare 50% of BTC and 50% of USDT, but the traditional market maker will confirm the "reasonable price" of BTC and place orders at this "reasonable price" to buy low and sell high. If BTC suddenly falls sharply, the traditional market maker will analyze the reasons for its decline and determine whether it will be lasting. If it is lasting, the traditional market maker will stop buying low and start selling low to balance its inventory ratio. When the decline ends, the traditional market maker will start "buying low and selling high" again. At present, there are services in the cryptocurrency field like Humming bot that specialize in providing traditional market making strategies for ordinary users, but their popularity is far less than that of automated market makers.

The advantages of automated market makers and traditional market makers are a bit like the two sides of a coin, and you can’t have both. On the one hand, although automated market makers cannot “withdraw” liquidity at any time when the market falls like traditional market makers, LPs can earn most of the fees and participate in liquidity mining. On the other hand, traditional market makers can more flexibly judge whether the current market situation is suitable for market making, which greatly reduces risks.

Simply put, in a bull market, automated market makers will bring higher returns to LPs than traditional market making strategies; in a bear market, traditional market makers' market making strategies will look much better than automated market makers.

Welcome to read Wu's selected reports : exclusive news of mainstream exchanges , Bitmain series , supervision and card freezing series , Filecoin series , currency circle chaos , mining farm supervision news , etc.

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