Automated Market Makers: The Foundation of DeFi

I view the DeFi (Decentralized Finance) ecosystem as a myriad of co-evolving protocols. In nature you have species forming symbiotic relationships and in most cases, resulting in a thriving community. This analog can be fittingly applied to DeFi as a whole. To illustrate, Sushi and yEarn recently announced a collaboration which would mutually benefit both protocols. In sum, Andre Cronje is leveraging the liquidity pooled on Sushi to build a derivatives trading platform dubbed Deriswap. Additionally, the two projects will adapt changes and connect treasuries to participate in each other’s governance processes.

This symbiotic interaction is not limited to these two protocols. Instead, I believe with more users, developers, liquidity, and investors entering the space we will witness a Cambrian-like explosion in DeFi innovation. At this point I am convinced DeFi will eat away at legacy finance until they are completely cannibalized. Given my outlook, I have been exploring opportunities in the space. Outside of derivatives, I believe automated market makers (AMM’s) have a high probability of capturing most the value on DeFi. In this write-up I hope to explain and justify my thesis.

AMM’s are a core piece of the DeFi infrastructure. I would argue a deep liquidity pool is required before any adjacent or vertical primitive can be be built. The market’s acquiescence to this view can be observed through the actions of blockchains outside of Ethereum. NEO, QTUM, and ONT have all started their DeFi pivots with decentralized exchanges.

The explosive DeFi growth on Ethereum would have been constrained without the innovation ushered by Uniswap. For the first time, projects were able to immediately list their tokens and procure liquidity through incentivization schemes (liquidity mining). Also, retail investors by providing liquidity were given the opportunity to act as the market makers. Prior to this, exchanges and a handful of large investors were the only actors benefiting from market making. This permissionless model created the foundation for this summers DeFi mania.

Like with any breakthrough and transformative technology, Uniswap had its short comings. Users who provided liquidity were subject to impermanent loss (IL). Moreover, users are required to gain exposure to assets if they desired to be liquidity providers. In short, this resulted in people losing some of their assets when the price appreciated significantly. Other AMM’s, like Bancor, have built solutions to resolve this problem by subsidizing IL and permitting single sided liquidity provision. However, only approved tokens are eligible to be listed. This brings me to the second major flaw with Uniswap. Since tokens are listed indiscriminately, many scammers seized the opportunity to exploit retail investors. Moreover, savvy actors deployed bots to front traders during initial DEX (decentralized exchange) offering hosted on Uniswap. Despite the inherent flaws, the total value locked on Uniswap continues its upward trajectory.

Outside of the derivatives market, I believe most of the value in the DeFi ecosystem will end up on AMM’s. The two market activities most investors consistently seek out are trading and yield generation. Looking at legacy finance you observe the same pattern. However, with the innovation of AMM’s you can build deep liquidity with very little coordination and mobilization. With the incentives properly aligned for all actors, self-interest facilitates all salient activities. Furthermore, being borderless enables the circumvention of regulations to create a global liquidity pool. Notably, competitors have surfaced which, in most industries, would lead to liquidity fragmentation. In contrast, due to the permissionless nature of DeFi, third party yield aggregators such as 1inch have largely resolved this matter. This project will route orders through multiple AMM’s in an effort to minimize slippage and obtain the best price for users.

Currently, most of the liquidity in crypto is found on Ethereum-based AMM’s. The aggregate volume on AMM’s has at times exceeded the volume of large centralized exchanges (CEX’s). Due to the open source culture of DeFi, it takes less resources to exceed the growth of CEX’s. Uniswap took a few developers and $1.8 million from a seed round to reach $1 billion in volume. This is only the beginning. Open source technologies typically are slow to start but with sustained momentum will achieve an exponential growth rate. We have observed the power of compounding network effects with the rise of AMPL this summer. Ampleforth prior to providing liquidity incentives through their Geyser program was an obscure project. With the aide of Uniswap and its user base, Ampleforth’s elastic currency AMPL almost hit a market cap of $1 billion in two short months. As we see more collaborations like this, I believe AMM’s will one day cannibalize CEX’s.

In summary, it is clear AMM’s have tremendous potential and are well positioned to benefit from the DeFi boom. Unlike the previous cycle where most tokens only appreciated due to their speculative value, DeFi protocols are delivering working products and generating cash flow. Moreover, some provide a solid value capture proposition for token holders. In other words, for the first time it is possible for tokens to derive value from the platforms’ growth and adoption. In the AMM space, there is one DeFi token with this thought process in mind. The Thorchain protocol is aiming to be the industry’s first chain agnostic AMM. Their protocol token RUNE will be pegged 1:1 to every asset in the pool. Additionally, all nodes through the incentive pendulum will be encouraged to maintain a 2:1 peg with all assets in the pool. This means the value of the RUNE would be equal to three times the total value locked in the pools. For perspective, if Thorhchain achieves Uniswap peak market cap, RUNE would trade at a minimum of $22.50. To learn more about Thorchain and it’s value proposition, I encourage going through my Thorchain playlist. The video below is a good place to start.

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Newly minted programmer, crypto maximalist, keto diet adherent, polyglot, part time swing trader, political scientist, PharmD, writer for Altcoin Magazine.