The development and opportunities of the next generation of DeFi automated market makers

The evolution of exchanges

For most people, the first entry point into the crypto world is often a centralized exchange such as Coinbase or Binance. Considering the ample liquidity, ease of use, and people’s familiarity with the classic order book mechanism used by such exchanges, their popularity is easy to understand.

However, in the blockchain/crypto world where decentralization is the priority, it always feels a bit awkward to rely entirely on centralized exchanges (CEX), especially since users’ funds are held in custody by the CEX and the assets available for trading are also determined by them.

Thankfully, decentralized exchanges (DEXs) developed on Ethereum, such as 0x and DDEX, emerged, offering non-custodial funds and censorable smart contracts. However, these DEXs still use the same order book model as CEXs. In addition to worse UX/UI, they often have a severe lack of liquidity.

In the world of Web 3, DeFi is the engine for democratizing financial services. It would be inappropriate to rely on mechanisms from the "traditional world" at this time. This requires us to fundamentally rethink exchanges and liquidity .

The emergence of automated market makers

Led by Uniswap, automated market makers (AMMs) were introduced to the crypto world and quickly became the archetype of DEX, bringing liquidity to DeFi. Essentially, an AMM exchange no longer relies on an order book model, but instead pools the liquidity provided by others and makes markets based on deterministic functions. Traders can get better liquidity, while ordinary users can get a share of the profits from transaction fees by providing liquidity with idle assets.

Combined with the incentives provided through liquidity mining, AMMs have experienced explosive growth as liquidity can now be “crowdfunded” and the market-making process has been democratized. In September 2020 alone, Uniswap’s trading volume reached $15.4 billion, almost $2 billion more than Coinbase’s volume for the same month. Currently, over 93% of DEX share belongs to AMM exchanges, and the model has proven itself to be the innovation that brought decentralized trading to the masses.

But AMM is not a perfect solution in the strict sense. It does have some limitations, such as low capital utilization, additional risk exposure, and the widely discussed problem of impermanent loss. Liquidity providers (LPs) have realized that market making is risky and impermanent loss may occur. The reason for this "loss" is that LPs can get higher value just by keeping their assets in their wallets.

The core of DeFi has always been the simple and straightforward pursuit of efficiency and returns. Whether it is providing loans on decentralized lending platforms or providing on-chain liquidity, it is to ensure that capital is never idle but is continuously put into use.

Although AMM itself has helped democratize liquidity provision, the current model still needs further innovation to better fit the spirit of DeFi.

Next-generation liquidity provision solution

As rapid innovation in the DeFi space becomes the norm, alternatives to the AMM model have quickly emerged that better address the shortcomings of liquidity provision. For example, projects like DODO, COFiX, and Bancor are providing new and innovative solutions to existing problems.

Problem 1: Low capital utilization

One of the main problems with AMMs right now is how the liquidity provided by LPs is allocated. For example, Uniswap allocates funds uniformly across the entire price range, which means that only funds allocated near the market price can really be used effectively, while the rest of the funds are idle. This leads to high slippage and inefficient capital.

In this case, the market maker algorithm must be more "intelligent", more like the human market makers in CEX, able to continuously adjust their orders according to changes in market prices.

The next generation of liquidity supply solution proposed by DODO - the Proactive Market Maker (PMM) algorithm - is a good example. In stark contrast to the AMM model, PMM uses a price oracle and plans to imitate real-person market making by aggregating liquidity near the market price.

Due to PMM's flat curve, traders will be able to benefit from lower slippage. In addition, even if the market price changes, PMM will actively adjust the price curve to ensure that there is still enough liquidity. This ensures that the capital utilization rate can be maintained at a high level, providing slippage comparable to Uniswap even with only one-tenth of the liquidity .

In the world of DeFi, liquidity is as precious as oil, and everyone is competing for LP's assets through various incentive programs, and a decisive advantage of liquidity provision solutions is their capital utilization . Only those models that can provide traders with competitive liquidity and low slippage even without locking up a large amount of assets can ensure long-term success after the liquidity mining incentive program ends.

Question 2: Additional risk exposure

Another obstacle that most retail investors encounter in terms of liquidity provision is that since AMMs such as Uniswap require the supply ratio of the two assets to be maintained at 50/50, they need to bear additional risks, and they are often unwilling to take such risks.

For example, if a user happens to have $100 worth of LINK tokens sitting idle in their wallet and is considering depositing it into Uniswap to earn a small profit from the accumulated transaction fees, they will have to deposit another $100 worth of another asset, such as ETH. This will result in additional risk exposure, as the value of the user's assets will now also be affected by ETH price fluctuations.

However, alternatives to AMMs have been developed that allow users to deposit only one asset, thus only having a single exposure. This can be achieved in several ways.

Taking LINK/USDC as an example, in DODO's PMM, each asset in a trading pair has a separate pool, resulting in two parts on the price curve, the buy side and the sell side, determined by the number of tokens in each pool. This is the opposite of the single, larger 50/50 pool in Uniswap's AMM. In this way, LPs only need to deposit assets according to the risk level they can accept, without having to buy unnecessary assets just for market making.

Other AMM alternatives that address this problem include CoFiX, where you can deposit any amount of a single asset. However, this approach is inherently risky because LPs’ assets may depreciate due to the constant changes in liquidity pool ratios, so LPs are encouraged to adopt hedging plans. By mirroring the changes in liquidity pool ratios on another market, users will be able to effectively hedge their positions, thereby offsetting negative volatility and locking in profits gained through market making.

While the mechanism of balancing liquidity pools by requiring users to deposit two assets has achieved the desired effect so far, as more retail investors enter the field, this approach will find it difficult to continue to achieve the desired results. Therefore, ensuring single asset exposure will become a basic requirement for most liquidity provision solutions.

Problem 3: Impermanent Loss

When LPs realized that they could actually make more money just by holding onto their assets, without having to provide liquidity to the AMM, they first learned about the concept of impermanent loss. Although there have been many articles that have extensively discussed this topic, in essence, simple AMMs are overly simple in design.

AMMs like Uniswap are based on the "Constant Product Market Maker (CPMM) Model" to calculate asset prices and balance liquidity pool ratios according to the equation x*y=k. This is because Uniswap itself cannot understand the true equilibrium market price of an asset, so when the price on Uniswap is different from the external market price, it requires arbitrageurs to enter the market immediately to buy assets at a discount and balance the liquidity pool in use again. But for LPs, this essentially means that since the AMM itself cannot perform its duties, they need to pay arbitrageurs to advance the price discovery and verification process.

However, there are several solutions to this problem, which usually use decentralized oracles to minimize the impermanent loss LPs suffer.

Taking CoFiX as an example, in theory, there is no impermanent loss because arbitrage is not possible from the beginning. Instead, CoFiX uses the Nest protocol as an oracle to provide a balanced market price for its assets, while adding a slight premium to the market quote, thereby pricing the calculable risk in each transaction and compensating LPs for the risk they take. However, this solution can only help LPs effectively lock in the profits they have made when combined with the hedging plan mentioned above.

DODO's PMM uses Chainlink for decentralized price feeds, replacing the CPMM formula for price discovery. However, there is still the problem of changes in the proportion of the liquidity pool, and LPs cannot withdraw the same number of tokens as they deposited. Therefore, in this case, DODO encourages arbitrage trading through their PMM. PMM will make slight adjustments based on market prices to ensure that there is enough profit to encourage arbitrageurs to enter and rebalance the liquidity pool.

Another alternative to reduce impermanent loss comes from Bancor, which essentially introduces insurance to ensure that LPs can get back at least 100% of their initial capital plus all accrued fees. This is achieved through the elastic supply of BNT, which allows new BNT tokens to be minted on demand. At the same time, its feasibility also requires that the long-term cumulative returns obtained through market making are greater than the impermanent loss suffered by the liquidity pool. The details of this mechanism can be found in this link.

Moving forward together towards the future

A key takeaway from the various approaches outlined above is that while liquidity provision has been democratized, market making is not for everyone.

There is no such thing as a free lunch, and there are often complex risks involved, so individual LPs must decide for themselves whether they are willing to take the risk. As liquidity mining rewards begin to decrease, we may see that retail LPs will no longer have such a strong motivation to contribute liquidity, which will in turn affect the liquidity and performance of DEXs.

There are several possible ways this could unfold in the future.

The first is the increase in professional market makers in DEXs who are willing to bring their liquidity to DeFi because there are obvious profit opportunities. To do this, they need to have more freedom, both in forming their own parameters and in their own pools.

The second is to allow users to manage their risk in more innovative and efficient (but preferably simpler) ways. This is a core theme in DeFi and is naturally critical to DEXs. The goal should be to maintain the current low barrier to entry for LPs while reducing unnecessary complexity through methods such as insurance, risk tokenization, and even a whole set of supporting tools.

From this perspective, the best solution may be the one that DODO is currently studying, that is, more and more professional market makers will enter DEX, and by allowing them to customize their own on-chain market making strategies, they will be incentivized to transfer liquidity. In the future, retail LPs can also follow the same strategy to further reduce the complexity of liquidity supply.

In this case, traders can still enjoy the same liquidity depth as CEX, while enjoying the inherent advantages of DEX, such as no custody of funds, no permission to add support for new assets, etc. At the same time, as long as individual LPs are willing to understand and bear the risks, they can still continue to provide liquidity and get a share of the platform they are on, but ideally there will be innovations to help manage the above risks.

The world of DeFi is wild and imaginative, a whole new playground where innovation is given ample space to thrive or fail miserably. The growth of DEXs and AMMs we’ve seen so far is part of this, and will undoubtedly continue to play a key role in driving DeFi’s mission of democratizing financial access and services. But there are more possibilities to look forward to.

Get ready to go, the journey has just begun.