Although Crypto Twitter often seems like the dog from the movie Up, it does enable a diverse set of arguments to surface, and the space is small enough where conversations are not yet siloed, leading to a robust public debate on the topic du jour.
Automated Market Makers (AMMs) were that topic last week, in large part due to the runaway success of Uniswap. Some challenge the very foundation of the efficiency of AMMs, while AMM true believers and focused on how to dethrone Uniswap. I’ve consolidated these into 3 trends/debates below.
AMMs are inefficient and can’t scale
Most of the CT discussion was kickstarted by this thread from FTX CEO Sam Bankman-Friedman, which concluded with, “The past is orderbooks. So, I think, is the future”. His criticisms of AMMs are largely two fold:
Yield farming artificially inflates AMM TVL, volume and usability
Impermanent loss is an intractable problem
Regarding #1, UNI rewards have helped in recent weeks, but Uniswap volume and TVL were growing exponentially before the launch of UNI. New projects listed on Uniswap because it was the quickest and cheapest way to create a liquid market for a new token.
Impermanent loss remains either an unsolved math problem or is in dire need of a rebrand. Paradigm’s Dan Robinson did the best job of dispelling the myth that LPs are getting taken advantage of by arb bots. “Volatility harvesting”, as he puts it, can be a profitable trading strategy.
Former HFTer turned DeFi zealout, Tarun Chitra provides the middle ground in this discussion. Although he agrees with many AMM critics, he concedes that “the demand for passive investing vehicles runs much deeper than those who want rational asset prices are willing to believe”.
Most of the recent AMM criticisms are from traders. They fail to recognize that “AMM Liquidity Provider” is a brand new retail financial product. Much like the perennially underrated index funds, AMMs are more of a consumer product innovation (in simplicity) than a financial breakthrough (of complexity).
Some other great links on this topic:
Graphic from 0x’s Will Warren on how Market Makers could exploit AMMs
Andrew Kang – LPs can be profitable w/o incentives. “Single formula does not mean single strategy”
Cyrus Younessi – Uniswap AMM strategy acts as a Schelling Point for all LPs
Qiao Wang at Liquidity 2020 – What DeFi projects don’t understand about Market Making (But should?)
Alex Wearn at Liquidity 2020 – IDEX: Liquidity Wars: Order Book vs AMM
Can impermanent loss be eliminated?
For those that have turned into true believers, next is the quest for the holy grail of AMM strategy: eliminate impermanent loss (IL).
Mooniswap and DODO are AMMs that use oracles to adjust the price curve to reduce impermanent loss. This cuts into arb profits, but arbitrageurs are key to overall AMM efficiency. Moreover, the oracle price updates will get front-run, as Synthetix learned.
There were two related announcements this week for a single-sided AMM with an elastic token supply. Bancor announced a major v2.1 upgrade, while Andre Cronje teased a “liquidity based inflationary token that can offset IL via liquid governance”.
The Bancor update is already on mainnet and will be the first test of insurance for impermanent loss. The appeal for the LP is to be able to provide liquidity in a single asset, rather than token pairs.
Given the success of AMMs in 2020, it’s surprising that we don’t know more about their efficiency. Much of the discussion is theoretical. More time (and data) will change that. Paradigm’s Charlie Noyes posits three “Open Problems” for AMMs:
What is the expected return of a Uniswap LP?
What is the optimal fee to maximize LP wealth?
Can a Uniswap LP’s optimal growth rate exceed a buy-and-hold portfolio’s?
All this without getting into Balancer and Curve, who have already found product-market-fit in the LP market. Order books may not be going away but AMMs are just getting started.
AMMs – how to diversify into more assets?
AMMs -> we now have constant product, constant function, multi-asset, curve-shifting, vol-adjusting, etc. Will we see AMMs for time-decaying assets? Bonds, CDS, options are all huge markets coming on-chain where duration is one of the key variables for determining price.
October 14th 2020
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AMMs have begun to crack into CEX market share, but spot trading is only a fraction of overall trading volume. AMMs have proved viable for pricing fungible tokens because you can pool liquidity, but it’s not clear it works for assets that are hard to price, like options or any time-based derivative.
UMA, meanwhile, has tried to bootstrap liquidity for its yield dollar in a Balancer pool and provide an easy onramp for those that want to hedge future interest rates. While liquidity has flowed into the Balancer pools, it does not appear to be an efficient pricing mechanism.
Just today, Yield Protocol announced a beta launch on Ethereum mainnet. Rather than try and build liquidity on Uniswap or Balancer, Yield Protocol aims to introduce fixed-rate lending through an entirely new AMM that is optimized for maturing products.
Tweet of the Week: The value of Uniswap governance
Basically, UNI govern a limited set of parameters of specific deployed bytecode. Uniswap could deploy v2.1 tomorrow and fork out any assholes, create a new treasury, etc. and there would be nothing anyone could do to stop them, legally or otherwise. So who cares?
October 19th 2020
This tweet from crypto lawyer Gabriel Shapiro was in response to the failure of the first Uniswap governance proposal to reach quorum. The proposal – led by ‘Univalent’ was to lower the quorum needed to pass votes, but it failed to reach quorum itself. Rekt has an excellent run down of the days leading up to the vote.
Chart of the week: BTC on Ethereum
Nothing new here to frequent readers. I think Bitcoin is still an untapped market for DeFi, but the growth is still something to marvel at. WBTC now has 0.5% of all BTC in its custody, primarily backing loans in MakerDAO or farming UNI. Completely unrelated, this chart is part of an awesome new data dashboard section on The Block. Check it out and let them know that all the cool kids use ‘DeFi’, not ‘Open Finance’.
Odds and Ends
Coindesk: DeFi audit firms swamped by ‘overwhelming demand’ Link
Forbes big write up on leading DeFi VC Paradigm Link
DXdao* is sponsoring gas fees on prediction market Omen Link
Nexus Mutual plans major upgrades to protocol Link
0x Developer and Governance update October 2020 Link
Perpetual Protocol plans to launch on xDai Link
Gauntlet Finance launches risk scores for DeFi Link
Trading View announces support for Uniswap markets Link
Thoughts and Prognostications
Token-based Governance is a fantasy; start focusing on assigning executive power [Elad Verbin/Lunar VC]
Do vesting rewards work for liquidity mining? [Anil Lulla/Delphi Digital]
Q3 Token Report: The rise of the ownership economy [Bankless]
Ethereum enhancers, not Ethereum killers [Matt Finestone/Loopring]
Q3 DeFi Review: DeFi reaches peak exuberance before coming back down to Earth [Messari]
That’s it! Feedback appreciated. Just hit reply. Written in Brooklyn. Super heavy Paradigm edition. AMM > CFMM, memes are not about accuracy
Dose of DeFi is written by Chris Powers. Opinions expressed are my own. I spend most of my time contributing to DXdao*. All content is for informational purposes and is not intended as investment advice.