Giant Killer: Automated Market Makers vs. Centralised Exchanges
Prologue: This is part of my “Giant Killer” series exploring emerging FinTech verticals that could challenge incumbent oligopolies and flipping the status quo. Note that in FinTech, the path to success is usually by making “frenemies”, with a lot of room for collaboration and co-existence.
TL:DR
- An Automated Market Maker is a mathematical formula that provides a quote for a trade based on the current ratio of two (or more) assets in a pool of assets
- This allows trading to be done without a counterparty and an order book, making it decentralised. It is also relatively cheap
- These innovations are the building blocks of decentralised finance and could outgrow its centralised counterparts in Crypto, but the whole industry needs to gain traction to fuel long-term growth
Capital Markets are a two-way street, there’s always a real seller offloading something to a real buyer. Traditional Financial Markets are run by a few, centralised entities who could make drastic decisions such as co-mingling customer funds (FTX and Mr. Bankrun-Fried) or cancel trades like the London Metals Exchange. Crypto Technologists HATE being told what to do by these centralised folk and believe in a vision for a decentralised, peer-to-peer world. Automated Market Makers (AMMs) are created to realise that vision. In Decentralised Finance (DeFi), users can convert their Crypto into other Crypto through liquidity pools that are orchestrated via AMMs (I’ll refer to this as just “AMMs” in the blog). These innovations aren’t a small drop in the bucket either, and are already on the path to rival the volumes posted by large Centralised Crypto Exchanges — so do they have a shot at dethroning them?
How do AMMs Work And What’s Their Value?
Bancor, Uniswap, Sushiswap et al. adopted a mathematical formula that is able to always give a quote between 2 or more assets. An AMM protocol allows for users to be constantly able to trade their Crypto, provide liquidity and instant settlement.
These trading operations consists of a liquidity pool (as mentioned earlier) that contains 2 or more assets/tokens and a specific mathematical formula (the AMM). Before illustrating with an example, let me explain how it works using a very basic AMM formula: y = k/x.
The fundamental idea of AMM is that the more Asset X you try to add or remove from this liquidity pool, an even larger amount of Asset Y is needed or vice versa. Looking at the figure above, removing a dy amount of Asset Y twice (dy + dy) would result in dx1 and dx2 being added to the pool, where dx2 is much larger than dx1. This will throw prices haywire and deviate significantly from other spot markets or the Asset’s fundamental value. This discount or premium is an arbitrage opportunity, encouraging traders to trade on this Asset on the AMM protocol and do the opposite trade on a spot market. In this example, a trader would add dy back into the pool to get out a large amount of asset X (approximately dx2) and sell that dx2 on the spot markets to get back an amount larger than dy. This nets the arbitrager a small profit and brings the prices in the AMM back to equilibrium as dy is added back in the pool.
With this mechanism, the AMM will always be able to quote a user, albeit at a shittier rate. Thus, allowing users to be able to trade, no matter what the liquidity situation within the pools look like. And since the assets are already in the pool, settlement is instant because the user will get the converted Crypto simply by taking them out of the pool. Other benefits to the user also include potentially lower and transparent fees. The fees get paid to the liquidity providers, the “investors” who put their own tokens in those liquidity pools. The yield generated is powered by the trading fees that rack up from the pool. This isn’t a free lunch though, as price fluctuations away from equilibrium can cause catastrophic, impermanent losses. All these benefits and transparency in AMMs created a strong demand and stickiness for Crypto trading to occur through these protocols, representing a small, but significant chunk of the market.
Headwinds For Centralised Exchanges Are Tailwinds For AMMs
As more CEXs go kaput and the more lawsuits get filed on Binance et al., the more volumes will migrate onto AMMs. Majority of the AMM volumes are also the “blue-chip” Cryptocurrencies trades (take a peek at Uniswap’s analytics page below). These volumes will make DeFi and AMMs even larger!
On 12th June (a random day that I decided to write this article), I was lucky to see that the 24 hour volumes through AMMs almost added up to Coinbase’s 24 hour volume (according to CoinMarketCap). This might be just a coincidence and there are definitely many days that Centralised Exchanges (CEXs) would have large volumes that totally dwarf AMMs. However, just stop for a minute and appreciate the scale that has been achieved by these mathematical and logic formulae that’s trading on autopilot — no other challenger in my Giant Killing series has this kind of traction so far!
Even though regulators are cracking down on Crypto and the mood is relatively bearish (and FUD-dy) for now, there is a growth opportunity for AMMs and DeFi in the short and medium term. In the long-term though, the fate of AMMs are uncertain because its growth will be tied to the success of the wider Crypto industry, which won’t come easy…
The Same Factors Holding Back AMMs Are Holding Back Crypto
I’m sure you’ve heard many fat finger or “today I screwed up” type of stories on Crypto, with my personal favourite being someone who tried to trade 2M USDC to USDT through an AMM, and ended up with only 0.05 USDT (a 99.999998% loss). Remember in my earlier explanation that the larger the amount you are trading (taking out of the liquidity pool), the shittier the price you get! That happened to someone who probably didn’t know how AMMs worked or mistakenly stumbled upon the interface to trade using AMMs rather than on the normal, spot market.
User-friendliness in Crypto, especially for these complicated products, is severely lacking. Crypto, especially in DeFi, has no customer service. Once you click confirm on that 2M USDC trade and get back 0.05 USDT, there is no going back. The user interface on Crypto trading apps must also specifically and explicitly state the differences between trading with real market participants and trading with a liquidity pool via an AMM algorithm. If there isn’t a solution to make Crypto more user-friendly, or easy enough to teach my Boomer Mum, Crypto or AMMs will never scale explosively.
Even if the process is very user-friendly, it’s still going to be a problem if the user has no idea how AMMs work but is still drawn to the product because of gamification or greed. Options, for example, are a highly complicated financial instrument that used to be only accessible to the financially literate, until Robinhood decided to use options as the main act for its casino. Crypto products can get really complicated, and AMMs are no exceptions. Despite having seen some really well-written, easy to understand guides out there, degenerates will not read them or simply brute force through a disclosure quiz to get access to such products on a Crypto platform just so that they can get that 100x gain porn screenshot.
User-unfriendliness, lack of education and Crypto’s speculative nature are ceilings that are capping the potential of AMMs. The Crypto market as a whole needs to do better, and real use cases (like cross-border payments) need to proliferate to improve its utility beyond being a casino. Even outside of Crypto, I believe that AMMs can be used in other markets like exotic currencies too. Perhaps the success of AMMs in the Crypto DeFi space will stir up some innovative interest to take AMMs on a vacation into other industries as well!
In Conclusion
AMMs are very intriguing and their popularity keeps on growing over the years as Crypto users realise the value of decentralisation. It will consistently rival the volume of major CEXs in the near future as more volumes migrate over to DeFi, but further growth beyond that will be less certain. Crypto as a whole needs to slowly detach itself from being a gambling den, builders need to make user experiences more seamless and idiot-proof. As Crypto continues to survive another winter, as more people use Crypto and as more people get digitally-savvy, traction should pick up, and that’s when AMMs can continue to grow.
