Crux of AMM: Yield vs Volatility

in LeoFinance16 days ago

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Automated market makers (AMM) are the future.

There's really no doubt about it. Sooner or later AMM is going to take over in a big way. This was a liquidity provider model that didn't make a lot of sense before yield farms, but now that yield farms are front and center the evolution of this model couldn't be more obvious.

AMM Evolution

Uniswap was the first popular decentralized exchange to really showcase the power of AMM. Tokens on Ethereum that would have otherwise had zero liquidity ended up having mountains of it, allowing those with deep pockets to buy a lot more of the tokens that they wanted without experiencing major slippage. But then what happened?

"Impermanent Loss"

Liquidity providers did the math a realized they were losing money. Some of them were losing A LOT of money even though the price of both assets involved was going up relative to USD. This didn't matter, as all that matters in AMM how how much the price of one asset changes relative to the one it's paired to. The ratio is everything.

Golden Ratio

Liquidity providers that sold their moonbag tokens by providing liquidity missed out on those gains and handed them over to the traders when the small caps ended up getting bought up vs ETH. Users began to realize that if they simply had not provided liquidity to the market they would have been up more money in the long run.

Why is that?

Because there is no way to make money using AMM without some kind of yield. Uniswap provided a yield of 0.3% in the form of exchange fees. This yield, when combined with the extreme volatility of crypto, became a sick joke. The risk for providing liquidity was not worth the reward, and thus modern day yield farms were born.

The tenant behind yield farming as it stands now is that inflation should be allocated to incentivize extremely heavy liquidity to enter the pools. Many yield farming tokens delegate most (if not all) of their inflation to the liquidity providers. It is through this massive incentive that turning 2 assets into LP tokens becomes extremely profitable in the long term even in the event of volatility. In fact, the yield balances out the volatility quite a bit.

Asset vs Liability.

In yield farming, the yield is the asset and volatility is the liability. The more money is allocated to the LP tokens, the more liquidity will compete for yield. The more volatile the market is, the more "impermanent losses" there will be to punish the liquidity providers for dollar-cost-averaging via smart-contract.

It doesn't matter if the market goes up or down, volatility in either direction is an automatic loss of funds for users providing liquidity to markets. On a centralized exchange with a traditional orderbook, liquidity providers can make money by placing buy and sell orders with a gap in the middle. The difference is profit. AMM does not allow this as all tokens are for sale at the same determined price via the algorithm in question.

Should I join an LP?

When deciding to join an LP or not, we only have to ask ourselves one question: Does the reward outweigh the risk? We must weigh the chance that slippage could be so high that the yield received doesn't offset the perceived losses. That would make it not worth it.

However, now that all these farms out there are generating quite a hefty sum in terms of APR it seems as though it's almost always worth farming liquidity pools rather than simply holding the asset. These yields are thus far quite massive compared to the slippage involved.

Paired to a stable coin.

Pools that are paired to a stable coin have even more utility than those that do not. LPs that are half stable-coin have square-root volatility protection to the downside. A declining price doesn't hit nearly as hard because half of all the value is stable, and the yields are massive. Of course, the same is true to the upside, and if your token happened to x100, your stack in the LP would "only" go x10.


Liquidity is the killer dapp

This is a statement that gets tossed around a lot these days. Liquidity matters quite a bit. It is said that Bitcoin holds the crown, but for how long? How much inflation does Bitcoin allocate to increase its liquidity?

0%

In the long run it stands to reason that because Bitcoin provides zero incentive to create an AMM pool, it will eventually fall by the wayside due to it's boring nature as a deflationary security-based asset. Sure, there are some pools today that provide yield paired to Bitcoin, but can you even call that Bitcoin? That's just a centralized token on the defi platform pegged to Bitcoin through a gateway of trust. The users who actually control the Bitcoin are the ones who enforce the peg. Pretty risky if you ask me, which is the opposite of what Bitcoin stands for.

How much liquidity are we talking here?

AMM provides somewhere between x10 and x100 the liquidity of traditional order books. As the underdog technology, many huge centralized exchanges still provide more liquidity in terms of USD because they service the higher market cap coins. However, when we look at what percentage of the network can be bought/sold in a short timespan AMM is going to win ten times over.

For example, anyone could buy/sell around 2% of all CUB in supply right now and only experience 5% slippage. Meanwhile, if someone tried to do that with Bitcoin everyone would be losing their shit and it would take weeks to accomplish. If someone tried to buy 2% of all BTC at once ($13B+) the price would likely have to double or more.

These are the kinds of exponential numbers we are dealing with here. AMM is fully superior to order books IF the pool can provide good incentive for users to allocate liquidity there. With order books, no such incentive is required and money can be made by gambling with price differentials and using market making bots at the high levels.

Conclusion

The only thing that matters when it comes to AMM technology is the yield provided to the farmers compared against the volatility of the market being made. High volatility means high yield is a requirement, or the market will fail. Luckily with the way yield farming works, when competition decreases yield is automatically raised for everyone still remaining in the pool. The new model is a self correcting free market that regulates itself. Powerful stuff.

Going forward AMM will continue proving how superior it is to order books, and will eventually get adopted into the legacy economy. The stock market will be turned into yield farms. If there's one thing I learned from all this it's that people love passive income and whales hate paying slippage costs. AMM fixes this, but it comes at the crux of providing yield to incentivize the whole process.

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💥Boom!💥

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Agree, damn good article!

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In the Case of CUB, i like to hold the CUB token. Simple Risk/reward looks nice. I don't want 100% APY if i can have a 1000% price pump. Makes to me no sense to play the game for a short term.

Den will be the long term winner. Its like time in market beats timing the market, in the case of good projects.

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Those are benefits of dens versus LP or yield farming.

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Well I am still planning on putting my funds into the farms. I think I have seen the liquidity get affected quite a bit as one moves and the other doesn't. However I still think the harvested CUBs make it worthwhile.

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Good returns there which balance out loss from I.L.

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Sure, there are some pools today that provide yield paired to Bitcoin, but can you even call that Bitcoin? That's just a centralized token on the defi platform pegged to Bitcoin through a gateway of trust.

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Ser have you met Thorchain? Native BTC pooling ser

LOL Hmmmm good point.

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I was going to bring that up but it's not like BTC is going to incentivize that farm. That's all on Rune to incentivize liquidity.

I don't know enough about the tech but there's no way there's zero extra attack vectors added even though it's "native" Bitcoin.

As far as yield farming is concerned it doesn't really matter if the token is pegged or not. The point is how do we incentivize LP providers. Bitcoin can't.

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I was going to bring that up but it's not like BTC is going to incentivize that farm. That's all on Rune to incentivize liquidity.

Yep, true, Rune does the incentivizing...

As far as yield farming is concerned it doesn't really matter if the token is pegged or not. The point is how do we incentivize LP providers. Bitcoin can't.

Bitcoin can’t. I agree with this

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thanks for this beautiful write up. Obviously it can be seen that the AMM has lot of benefits

thanks for sharing


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Agreed

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The future is the yield markets, people love to earn passively while they sleep and so do I. For the best APYs, I stake a number of coins, largely $AWC from https://atomicwallet.io/ which an APY up to 23%.

Just learning about AMM and am inspired. Thanks for the detailed information
Sounds interesting with a lot of benefits attached.
Wouldn't mind learning more about it, of course who wouldn't love passive income and the fact that it fixes paying slippage costs makes me more interested.

Good summary of liquidity pools, exchange fees and yield farms. Not to mention a quick sequel on stable coin farms. Good stuff.

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Agreed.

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Bingo! I think your spot on.
I agree with your points and add wLEO-Eth to evidence.

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I really love this information, kudos to you

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There are so many chains and platforms offering various types of Defi..

Eventually they are going to have to merge and partner I think. Many or most aren't holding value.

Staking on other stakes, is still a money printing game.

I mean it's a great game and I love it, but it will not last forever.

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True…the question is how long, and as long as you keep assessing the environment like a nervous gazelle on the plains and are prepared to remove liquidity and cash out quickly, LP on… LOL 😂

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lol, great example!

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I keep rereading this because there’s a lot here to unpack. Even though I understand why what your saying is correct I still like to read it so it sinks in…

I definitely agree with your points and I have lived with Tron,Uniswap, and now Cubfinance and PanCakeSwap, plus on the Polygon side learned lessons from PolyZap, Polycat and of course Iron Finance.

I think your dead on or spot on…

LPs provide capitol in the form of dollar equivalent asset pairs earning transaction fees on Uniswap and project token inflation on yield farms. The printing of project tokens is inflation and inflationary, plus creates selling pressure as yield farmers convert project tokens to Eth, btc and other non-project tokens…

LPs suffer impermanent loss which if it isn’t balanced by transaction fees must be balanced or really exceeded by project token inflation given as rewards. Otherwise non-one wants to provide liquidity.

Stable coin pairs eliminate impermanent loss and stable coin to non-stable coin pairs half it. I have lived these things and declare they are real.

The truly amazing thing is that this whole DeFi LP ecosystem isn’t going away… probably never….
And if we amass enough crypto we will be able to generate enough income to never work again.

And if by some tragedy we lose everything, we have the knowledge to rebuild our fortunes again. This knowledge makes us free.

That’s what is truly amazing.

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Ironically I was thinking along similar lines in this post: https://leofinance.io/@shortsegments/the-evolution-of-liquidity-provision-right-before-our-eyes

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