Crux of AMM: Yield vs Volatility

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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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