Decentralized exchanges (DEXs) are a fundamentally different way to trade crypto assets. Rather than using limit order books and the dealership model, they rely on market making, which is a process of creating liquidity and facilitating trades between traders.
A market maker is a financial intermediary who guarantees to buy and sell securities at specified prices, thereby eliminating the need for sellers to actively look for buyers. This is a time-tested system that works well in traditional markets. However, it can be problematic in the crypto world due to its lack of centralization. In the case of a DeFi exchange, this would be counterproductive to the ethos of democratizing financial services.
Liquidity Pools and AMMs
In DeFi, AMMs are a key component of the ecosystem and help to democratize liquidity provision. These are a form of smart contracts that pool together the liquidity of multiple users and make markets according to deterministic algorithms. This allows DeFi users to gain access to increased liquidity and trading fees simply by providing the liquidity that is already being held by others.
Market makers are often compensated with governance tokens or other benefits for facilitating trades on the platform. In the case of Uniswap, SushiSwap, Curve Finance and Balancer, these AMMs run billions of dollars worth of trades on a daily basis, and have been the driving force behind DeFi liquidity.
AMMs and the Crypto Liquidity Ecosystem
AMMs are a vital part of the DeFi market making ecosystem, and their innovations have helped to democratize the provision of liquidity. While AMMs are in their infancy, there are many innovative designs being developed that could lead to lower fees, less friction and ultimately better liquidity for all DeFi users.
Some AMMs have introduced a variety of risk mitigation measures to reduce the potential for Impermanent Losses and the amount of inventory that is at stake. This includes insurance and risk tokenization, as well as a range of other tools.
While these methods have helped to reduce the negative aspects of market making, they also have their limitations. These include a lack of control over how they are structured, and the potential for Impermanent Losses.
To mitigate these risks, some projects are introducing risk-tokenization techniques that allow market makers to create their own pools and parameters and manage their risk in more innovative and effective ways. For example, DODO is using a suite of tools to provide more flexible market making, allowing MMs to diversify their inventory and mitigate their risk.
Other AMMs are developing more streamlined solutions to manage the process of creating and managing liquidity pools. These include enabling AMMs to pool their liquidity from multiple sources, rather than requiring them to hold their own LPs. This would allow MMs to provide better liquidity and decrease the amount of time it takes to set up a pool.
AMMs are a vital part of DeFi’s liquidity infrastructure, and they have the potential to democratize the provision of liquidity in an even more powerful way. But, if these models are to succeed in aligning with the ethos of DeFi, they must be further developed and implemented.