Liquidity has long been a central concern, not only for cryptocurrency and blockchain projects, but for financial markets in general. It is a prerequisite for the growth of a project, financially and otherwise. Efforts have been made to solve the liquidity problem by providing it from some concentrated or centralized venue. But this conflicts with the decentralization ethos itself of the DeFi economy.
DeFi is aiming to create a financial system that’s open to everyone minimizing one’s need to trust and rely on central authorities. The latest “hype” in crypto markets, triggered by the AMMs (Automated Market Makers) and their Liquidity Mining protocols, is unprecedented in the history of financial markets. As much as it is an impressive achievement in building decentralized institutions, the decentralization per se can only be as decentralized as the sources of its liquidity.
When liquidity is truly crowdsourced from a diverse audience whose behavior and interests are uncorrelated, liquidity is fundamentally more robust. It is less likely to evaporate in a crisis and more indicative of a healthy market.
Hence, the health of DeFi is largely identical to the health of decentralized liquidity venues.
Birth of Liquidity Mining
Liquidity is one of the most important requirements for all financial assets and trading venues. However, many market participants are unclear as to what drives liquidity and how to measure its effects. This is because market making, the business of providing liquidity, has traditionally been accessible to only a limited number of participants, such as quantitative hedge funds and trading desks of large financial institutions. Crypto exchanges and token issuers spend an estimated $1.2 billion per year compensating market makers, typically quantitative hedge funds that specialize in crypto assets, in the form of rebates, fees, and opportunity cost of inventory.
At the heart of the DeFi lies the ability for people to make extraordinary returns (25% per year) simply by becoming a lender. The promise from the platforms has been that lendings are safe: smart contracts will guarantee collateralization of more than 1:1. In other words, more money is locked into a platform than is being lent out at any given moment. As people hop from platform to platform looking for the best rates to “lend” their crypto, a new term — yield farming — popped into existence to give the whole enterprise a feeling that “real” work was being done. There is a frenzy among the crypto asset holders to stake their assets for high returns in liquidity mining.
The DeFi Hype & AMMs
From $1 billion TLV (Total Locked Value) in June, 2020 to $14 billion on November 30th, 2020, the growth of DeFi has been more than exponential. A reminiscent of the 2017 ICO hype, the first generation of DeFi dapps rely heavily on collateral as a safeguard, meaning you already have to own crypto and provide it as collateral in order to borrow more crypto. Unsecured borrowing and lending will have to rely on a universal credit system if it is to become mainstream. Nevertheless, that may not be an immediate concern for a brand new “liquidity mining” industry that’s enabled by proliferation of the AMMs (Automated Market Makers) overwhelming DeFi with over 1,000% growth in just 5 months. The concern is whether the AMMs can sustain the growth.
The “hype” in crypto markets triggered by the AMMs and their Liquidity Mining protocols is unprecedented in the history of financial markets. As much as it is an impressive achievement in building decentralized institutions, the decentralization per se can only be as decentralized as the sources of its liquidity. But, if the liquidity is provided by a handful of whales instead of central banks, is there real decentralization? After all to centralize is human, to decentralize divine. When liquidity is truly crowdsourced from a diverse audience whose behavior and interests are uncorrelated, liquidity is fundamentally more robust. It is less likely to evaporate in a crisis and more indicative of a healthy market. Hence, the health of DeFi is largely identical to the health of decentralized liquidity venues.
Is AMM-Powered DeFi Sustainable?
The unprecedented growth in DeFi is having the critics ponder whether this new gold rush is just a hype or there is any substance to it. Are the current liquidity mining protocols and business model sustainable in the long term? We address that question and design a protocol that ensures long term sustainability of DeFi.
A marketplace driven approach can promote consistent liquidity provision, mitigate the risk of manipulative practices, and improve matching efficiency in the market for liquidity. Each token swap that a liquidity pool facilitates results in a price adjustment according to a deterministic pricing algorithm. This mechanism is orchestrated by AMM and liquidity pools across different protocols may use slightly different algorithms. The most simplistic liquidity protocol implemented by Uniswap that pairs low liquidity crypto with Ethereum at fixed ratio and price skews the constant product overtime in favor or against cryptos paired.
Uniswap’s constant product curve. Credit: Dmitriy Berenzon
Despite their popularity AMMs have following limitations, which may not show up in the current bullish market:
- Fixed fee by default,
- Always on quotes & trades commitment no matter what without stop loss is too risky,
- Arbitrageur exploitation risk due to price differences in different venues,
- Impermanent losses are inevitable in any market making scenario, and without a buffer the system will collapse in a bearish market.
On account of these shortcomings AMMs may apparently seem to be delivering in a bullish market, but they are likely to falter once the bulls are behind and bears rule the market.
NIOX Swarm — Autonio’s Liquidity Mining Protocol
A marketplace driven approach to market making can promote consistent crowdsourced liquidity provisions, mitigate the risk of manipulative practices, and improve matching efficiency in the market for liquidity. Intelligent market making solutions enable a fairer, true to the nature of decentralization, and a sustainable solution to crowdsourced liquidity. Using AI agents to create an intelligent network for market making is the next breakthrough that empowers a new class of crowdsourced liquidity that’s sensitive to price variations, stops losses, prevents arbitrageur exploits and most importantly buffers to minimize the impermanent losses.
Autonio’s liquidity mining protocol and infrastructure for crowdsourced intelligent market making incorporates:
- A marketplace-based approach to market maker compensation that leverages competitive dynamics to align rewards earned by market makers with risks that they bear in different market regimes.
- Reduce the coordination costs and improves matching efficiency between liquidity buyers and sellers by connecting liquidity buyers (sponsors) & sellers (market makers)
- Reduce arbitrageur exploits and impermanent losses that most AMMs are vulnerable to.
We’re thankful for all the support and are excited about pushing the boundaries of DeFi with our intelligent automated trading tools and infrastructure.