Cm cultists
Just read through the report dropped by @delphi on @Elixir democratizing
Liquidity Provisioning in the Age of Orderbooks
Decentralized Exchanges (DEXs) have experienced a vast evolution. While
the AMM was the first on-chain DEX design to find product-market-fit (PMF), it
was not the first attempt at on-chain trading. Counterintuitively, the earliest
DEXs closely mirrored more of an order-book model. At the time this seemed
like an intuitive place to start. Why not take what has worked in Traditional
Finance (TradFi) and apply it to crypto markets?
As we quickly learned, it is not this simple. The inherent gas costs associated
with providing liquidity on an Ethereum-based order-book is simply
uneconomical for market makers. Moreover, from the end-user perspective,
the benefits of trading on-chain are quickly offset by the cost of trading on-
chain. Taken to its logical conclusion, on-chain order-book DEXs would never
compete with their centralized counterparts.
This led to the advent of the OG automated market maker: the constant
function AMM (cfAMM). Instead of matching orders through complex
proprietary market making algorithms, the cfAMM executed trades based on
a simple mathematical formula (i.e., x*y=k). The deterministic nature of the
x*y=k equation imposed inherent constraints on market makers. On the
other hand, this considerably reduced the barrier to entry for providing
liquidity. The cfAMM enabled anyone to spin up a trading pair and supply
liquidity.
This had notable second-order implications. Importantly, retail participants
have structurally different incentives from centralized market making firms.
Unlike Wintermute or GSR, retail tends to have more of an appetite for
emerging token incentives. Consequently, by tapping into retail capital, the
cfAMM made it much easier to bootstrap liquidity. This enabled an efficient
on-chain alternative for trading both major token pairs as well as long-tail
token pairs previously left unmet by CEXs.
However, it quickly became evident that the cfAMM had its flaws. Namely,
this model spread liquidity thin across an infinite price range leading to poor
capital efficiency. This led to the subsequent advent of the concentrated
liquidity AMM under Uniswap v3. This model extended the degrees of
freedom that LPs have in providing liquidity. Instead of simply passively
supplying liquidity, LPs now provided liquidity at specific “price ticks”. While
this model was certainly more capital efficient, it simultaneously raised the
level of sophistication necessary to provide liquidity. Accordingly, the
concentrated liquidity model began to look more “order-book-like”.
This model also suffered from additional shortcomings that seem to be
inherent to all AMMs. More specifically, AMMs are subject to two symptoms of
MEV: (1) slippage and (2) Loss-Versus-Rebalancing (LVR). While both
concepts are beyond the scope of this report, it is worth briefly touching on
them.
Slippage is value that is extracted from traders through frontrunning or
sandwiching attacks. LVR on the other hand is the value extracted from LPs
through CEX, DEX arbitrage. This is often referred to as “toxic flow”. Recent
research suggests that due to LVR, LPs on AMMs may not actually be
profitable. Given the importance of LPs to provide efficient execution for
traders, reducing LVR has become the primary focus within the on-chain
trading community.
There seem to be two different approaches to these problems. The first
approach is underpinned by a collective ethos that believes preserving
democratic liquidity provisioning is imperative. Those subscribing to this
belief are working tirelessly to build out novel AMM designs that reduce LVR
and return this value back to LPs. We will likely see more of these designs as
“hooks” under Uniswap v4.
The second and less popular approach is conversely underpinned by a more
pragmatic ethos. These individuals would say that market making follows an
inherently oligopolistic resting state. No matter what, there will always be a
handful of more sophisticated actors that find a way to extract value from
less sophisticated actors. Therefore, rather than trying to preserve
democratic liquidity provisioning, we should instead enable these more
sophisticated market participants to compete with each other on giving the
end user best execution. While slightly antithetical to crypto’s ethos, these
individuals would argue that this may be the necessary approach in the
short-term as the user experience appears to be stifling adoption.
Ultimately, these approaches can be distilled down to (1) those who are in
favor of AMMs and democratic liquidity provisioning and (2) those in favor of
RFQs, order-books, and best execution above all else.
