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Written by: Cui Chen, works at HashKey Capital Research Reviewer: Zou Chuanwei, Chief Economist of Wanxiang Blockchain AMM (Automated Market Maker) is currently the most popular trading model in the DeFi field. Different from the order book pairing method, AMM uses a fixed product method to convert tokens in the trading pool. Transactions can be automatically completed to ensure the liquidity of trading pairs. There are two participants in AMM, traders and liquidity providers (LP). LP will first inject a certain amount of tokens into the pool to provide trading liquidity and earn the transaction fees paid by traders. Generally, AMM protocols will issue their own governance tokens and allocate 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 referring to obtaining the native governance tokens of the project. This method is very common in DeFi. The project party uses this method to distribute 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 loss, LPs participating in liquidity mining cannot guarantee stable income. Whether the liquidity mining model can become a sustainable business model is an issue that needs to be paid attention to in DeFi. This article analyzes the sustainability of liquidity mining in AMM from the perspective of AMM traders and liquidity providers. Compared with other trading methods, the main advantage of AMM comes from complete decentralization. Specifically, there are two aspects: transparent trading methods and censorship-resistant usage. Unlike centralized trading platforms, DeFi's AMM transactions keep user funds in their own wallets, and transactions are completed through contract interactions rather than traditional deposit and withdrawal methods, which can avoid fraud and theft problems that occur on centralized trading platforms. Anti-censorship is reflected in the anti-censorship of user identities and trading pools. Users can trade without KYC, and the opening of trading pools does not require censorship. A large number of tokens in the initial stage can be circulated by setting up trading pools. Therefore, users can participate in the early stage, or purchase tokens of potential projects, and then obtain high returns. One of the advantages of AMM is that it conducts transactions automatically. AMM automatically exchanges through fixed products, which can ensure that transactions are completed in a timely manner and have sufficient liquidity, so that even large transactions can be completed.
The exchange rate in the AMM trading pool changes passively. Only trading behavior can adjust the token exchange rate, and the adjustment interval is the block time of Ethereum. If the exchange rate under the chain changes, the exchange pool exchange rate can only be adjusted to a normal level through the arbitrage behavior of traders. Therefore, in summary, traders’ motivation to use AMM comes from the transparent and decentralized trading method, the high returns of early projects, and the arbitrage opportunities on and off the chain.
Currently, the handling fees of two well-known AMM projects, Uniswap and Sushiswap, are both 0.3%, which is higher than centralized trading platforms, and additional gas fees on the Ethereum chain must be paid. Recently, gas fees have remained high, far exceeding transaction fees, but the trading volumes of Uniswap and Sushiswap remain at the forefront of all cryptocurrency trading platforms. Rational traders will definitely gain more than they spend in this process, which means that even with high handling fees, traders' demand for AMMs has always existed. Therefore, from the perspective of traders, the motivation to use AMMs is stable. Motivations of Liquidity Providers Impact on liquidity providers’ returns Liquidity providers in AMM can be divided into two types: one is the project party that provides trading channels for small currencies, and the other is the participants in liquidity mining. Here we only discuss the second case. The motivation of these LPs is very clear, just to pursue financial returns. The income comes from the trader's handling fees and the project's native governance tokens. In fact, LP returns are affected by three factors: trading 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 comes entirely from traders' expenses. Trading volume and fee rate are indicators that affect trading fees. Traders' exchange transactions will be deducted accordingly according to the fee rate, and the deducted part will be directly left in the trading pool. Under the condition of a certain fee rate, the greater the trading volume, the more fees will be earned. 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 number and price of native tokens distributed. The allocation qualification and quantity of the trading pool are determined by community voting. The distribution of governance tokens is based on the trading pool. No matter how the total amount of tokens in the trading pool changes, the number of governance tokens distributed within a certain period of time is fixed. There are two steps to receive native tokens. First, LP deposits a corresponding proportion of tokens in the trading pool and obtains the voucher LP Token. For example, if you deposit ETH-USDT liquidity pool in proportion, you can get ETH-USDT LP Token. Then, LP Token is pledged and exchanged for a corresponding number of governance tokens according to the individual's proportion of the overall. The LP's share of the liquidity pool and the value of the governance token will affect its income. After depositing the corresponding tokens, the liquidity pool provider will obtain the LP Token certificate, and then exchange this certificate for the two tokens in corresponding proportions when exiting. Then the change in 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: changes in the composition of the liquidity pool and fluctuations in the price of crypto assets. However, for liquidity providers, the initial principal will change due to fluctuations in the price of crypto assets even if it is not recharged into the liquidity pool. This article discusses the sustainability of liquidity mining, focusing on the impact on LP due to providing liquidity. It does not discuss the price fluctuations of crypto assets for the time being, but only focuses on the impact on LP due to changes in the composition of the liquidity pool, that is, impermanent loss. When the token exchange rate changes, LP will always suffer from impermanent loss because LP has been passively doing the opposite of the market. During the exchange rate change, LP always passively sells tokens with rising exchange rates and buys tokens with falling exchange rates. The exchange rate change is reflected in the change of the token ratio in the pool. When calculating impermanent loss, you only need to consider the exchange rate changes at the two moments when LP recharges and withdraws tokens. Calculation of liquidity provider’s profit Transaction fees and governance tokens are the income of the liquidity pool, and impermanent loss is the loss, so the return of the liquidity pool can be calculated based on these three items. The yield of each LP is equal to the yield of the liquidity pool. Obviously, if the transaction fees and the allocated governance tokens do not increase, the more tokens there are in the liquidity pool, the lower the overall yield will be. Here we take the ETH-USDT trading pairs in Uniswap and Sushiswap as examples to calculate the actual returns of LP after providing liquidity. Now Uniswap has stopped liquidity mining, and LP will not be allocated UNI when providing liquidity. Therefore, Uniswap only needs to consider handling fees and impermanent loss, while Sushiswap needs to consider the allocation quantity and price of SUSHI. The following data is for 24 hours from February 24 to February 25.
Figure 1: Uniswap and Sushiswap ETH-USDT trading pair interface The ETH-USDT trading interface of Uniswap and Sushiswap shows the current exchange rate, quantity, total value and value of the transaction fee in the pool. Therefore, we can calculate the initial proportion of the token and the impermanent loss suffered based on the current quantity of the token and the change in the exchange rate, taking into account the injection of transaction fees in the pool. Table 1: Impermanent loss calculations for Uniswap and Sushiswap/USD
The annualized rate of return of LP can be calculated based on impermanent loss, locked-up amount, handling fees and the value of distributed governance tokens. Table 2: Uniswap and Sushiswap revenue calculation/USD Among them, 77.3% of Sushiswap's annualized income comes from the income of distributed SUSHI tokens (calculated at a unit price of US$15 on that day). After the unit price of SUSHI drops, this part of the income will decrease. As can be seen from the table above, even if Uniswap stops distributing tokens to the liquidity pool, the annualized return of LPs remains high, which confirms the high trading volume of the top AMM trading platforms. From February 24 to February 25, if the income is only the handling fee, Sushiswap's annualized rate of return (17.0%) is much lower than Uniswap (60.0%), but with the addition of governance token rewards, Sushiswap surpasses Uniswap; at the same time, Sushiswap's ETH-USDT pool lock-up volume is higher than Uniswap. It can be seen that funds tend to projects with high yields. If Sushiswap's lock-up volume continues to increase in the future, its annualized rate of return will decline if the handling fee and governance token income remain unchanged. The distribution of UNI and SUSHI is based on the results of project governance and is a dynamic process. If the total income and liquidity in the pool are not high, token mining can be used to provide additional incentives. In the distribution of governance tokens, the total amount of tokens will be increased at a certain ratio every year in the future after the distribution is completed. The annualized return calculation in this section is based on data within 24 hours. The volatility of ETH-USDT on this day is about 6%. If the rise and fall of ETH in other periods of time is higher than the volatility on this day, and the handling fee level is lower than the level on this day, the annualized return of LP will decrease, otherwise it will increase.
Figure 2: Comparison of liquidity and trading volume of Uniswap ETH-USDT trading pair Comparing the liquidity and trading volume of the Uniswap ETH-USDT trading pair, the average liquidity has decreased compared to October last year, but the average trading volume has increased compared to October last year. If the impermanent loss is not taken into account, the income of LP is continuously increasing and very considerable. 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 loss. If the exchange rate when LP withdraws money from the pool is consistent with that when it is charged, then LP will not be affected by impermanent loss. Finally, it should be noted that the rate of return in this article is calculated based on the assumption that the total amount of the liquidity pool remains unchanged. If you want to calculate the LP rate of return over a long period of time, you also need to consider the impact of LP deposits and withdrawals on the total amount of the liquidity pool during the period. The sustainability of liquidity mining in AMM For AMM trading methods, the demand for on-chain and off-chain arbitrage and highly transparent and decentralized trading methods always exist, so the demand of traders always exists. But for liquidity providers, they will only be motivated to participate if they are profitable. According to the calculation method of liquidity provider income, it is mainly related to handling fees, the value of native governance tokens and uncompensated losses. The transaction fee is related to the transaction volume and rate. The transaction volume demand of users comes from arbitrage and real transaction demand. If the currency price fluctuates greatly, the short-term arbitrage demand will increase. The real transaction demand comes from the user's preference for decentralized transactions and the call of other Defi applications. Ethereum gas fees will also affect users' transaction preferences, because Ethereum gas fees are generally counted as transaction fees paid by users. The value of the native governance token The value of the native governance token directly affects the income of liquidity 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 locked-up volume, trading volume, and other functions. The amount of locked positions can indirectly determine the power of governance tokens. Even if governance power does not mean the right to use locked funds, the governance results will affect the amount of locked positions of the project. The amount of locked positions represents the liquidity basis of the project. Generally, the higher the amount of locked positions, the higher the value of the governance rights of the project. The amount of trading volume represents the actual usage of users, and the trading volume is directly related to the income of LP. Like the locked amount, the value of the governance token cannot be directly linked to the trading volume, but the trading volume can reflect the valuation of the project. The higher the trading volume, the higher the valuation of the project, so the increase in trading volume and users often means the increase in the value of the governance token. The platform tokens issued by centralized trading platforms generally have multiple functions, such as voting for listing, discounting transaction fees, paying gas fees for the exchange's public chain, etc. These functions give the platform tokens a certain value. Although the governance tokens of AMMs will not be designed the same as the platform tokens of centralized platforms, other functions will gradually be added. For example, in Sushiswap, only 2.5% of the 3% handling fee charged to traders is allocated to liquidity providers, and the remaining 0.5% is used to repurchase Sushi, and the value of the handling fee is added to the governance token. The impact of impermanent loss For liquidity providers whose costs are two tokens, impermanent loss is the only loss they may suffer. According to the calculation method in this article, impermanent loss is only related to the proportion of tokens in the LP's deposit and withdrawal liquidity pool. If the proportion of its tokens is the same at these two points in time, then the LP will not suffer impermanent loss. Therefore, when the exchange rate between the two fluctuates within a certain range, the LP can obtain fee income without suffering impermanent loss. If the exchange rate rises unilaterally, the impermanent loss suffered by the LP may be higher than the income. Using call options or designing impermanent loss insurance are attempts to control the scale of impermanent losses in the future. Thoughts and Conclusions The sustainability of AMM liquidity mining can be analyzed from two perspectives of the participants: traders and liquidity providers. If the transaction process can benefit both parties, then liquidity mining can be considered sustainable. Traders pay transaction fees and gas fees on the blockchain, and what they get is arbitrage profits, open and transparent security guarantees, and transactions that do not require review.
For LP, although they suffered from impermanent loss, they received transaction fees and possible rewards of native governance tokens of the project. At present, the annualized rate of return of LP is still very high. If calculated according to the current fee income, LP can obtain very high fee income by participating in liquidity mining. Token rewards are also a very important part. The number and time of token rewards in the trading pool are determined by the platform governance, which is very flexible. The inflation model of liquidity tokens can allow the issuance of tokens to continue. At the same time, the project party will design some other ways to lock the token design functions to add more value.
This article calculates the fiat currency yield 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 also need to be considered. If the value of the relevant token fluctuates, LP will be passively and forcibly affected, because LP cannot adjust its position, and the recharge and withdrawal of LP requires a lot of handling fees. Therefore, there are not many LPs who obtain principal for liquidity mining through borrowing. Generally, LPs own two tokens for the purpose of currency-based financial management. In this case, LPs need to pay special attention to the impact of impermanent loss. When the rise or fall is too large, it may cause the situation where income is difficult to compensate for impermanent loss. In general, liquidity 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 yields of various AMM projects will tend to be consistent and stable. |
