Automated Market Maker DEX Economics

Editor's Note: This article comes fromMoneyness Institute (ID: moneyness), Author: Chao Pan, Head of MakerDAO China, released with authorization.

Editor's Note: This article comes from"

Moneyness Institute (ID: moneyness)

Moneyness Institute (ID: moneyness)

, Author: Chao Pan, Head of MakerDAO China, released with authorization.

“If traditional exchanges are private hypermarkets, then Uniswap is a crowdfunding vending machine.

DEX (Decentralized Exchange), as the name suggests, removes all the centralized links that can be removed from traditional exchanges, from matching to clearing and settlement, and even market making.

Generally speaking, decentralized exchanges are mainly aimed at matching and settlement. Pure DEX puts these two processes on the contract on the chain. Hybrid DEX often adopts on-chain clearing and settlement, off-chain matching through servers or relay layers, and compromises partial centralization to support higher transaction frequency.

For different types of trading objects, DEX can adopt an order book mode or an over-the-counter trading mode that adapts to it. Whether it is the order book mode or the counter trading mode, the market making (Market Making) link is dominated by humans.

There is a special DEX, represented by Uniswap, which automates market makers (Automated Market Maker) and replaces manual quotations with established algorithms, which not only eliminates centralized matching and settlement, but also eliminates market makers in transactions. Therefore, it is very popular in the extremely decentralized world.

Before understanding the nature of automated market-making DEX, we first need to know what a market maker is.

Market makers are different from ordinary traders. They are risk-neutral, holding stocks in one hand and cash in the other. In order book mode, both buy and sell orders are placed, with the spread in between. Similarly, over-the-counter market makers will make profitable quotations when customers make inquiries.

Market makers are the source of liquidity, and a highly liquid market needs market makers, which in turn will attract large-scale market makers to participate. We often talk about liquidity. What are the characteristics of a liquid market?

A liquid market means you can quickly make a large purchase or sale without affecting the current price too much. Intuitively speaking, although the market with good liquidity will fluctuate in price, the trend is continuous and smooth, and there will be no intermittent gaps.

How can market makers guarantee continuous prices while earning the price difference? The two seem to be contradictory.

The answer is inventory.

Inventory is a time-based business. As long as the risk is controllable, market makers can use the inventories on both sides to absorb short-term demand changes without changing prices. Just like a large supermarket, although the flow of people in the morning and evening is different, the price of the commodity does not change within a day, thanks to the stock buffer in the shelves and warehouses. Wal-Mart is a highly liquid market: fast, large transactions, without affecting prices.

Wal-Mart Supermarket is a one-sided market and only provides liquidity for buying orders. The cryptocurrency trading market is similar to the stock trading market, requiring market makers to provide bilateral inventory and maintain a relative balance.

The picture above is not a price trend chart of a certain stock, but a stock ratio change and total capital constraints of a market maker.

The stock/cash inventory ratio of the market maker and the price movement of the stock are highly coincident. When people's demand for the stock increases and they start buying from market makers, the stock inventory of market makers will decrease and cash will increase; and when people are not optimistic about the stock and start selling to market makers, market makers will accumulate More stock, less cash. Since their own capital is limited, market makers will adjust the quotation after they believe that the inventory on both sides is unbalanced. If there are too few stocks in hand, consider raising the quotation to cherish bargaining chips. If there are too many stocks in hand, consider lowering the inquiry price to sell as soon as possible.

Therefore, changes in inventories are the result of changes in market demand and an indicator of prices, and further affect prices and supply and demand. To make a metaphor, the inventory change is the price makeup in the mirror, which will cause the price to adjust, but not the price itself.

What automated market-making protocols such as Uniswap fundamentally do is to use the mirror of inventory changes in liquidity pools to simulate price changes.

Everyone can join the liquidity pool, and only need to deposit the specified two assets, and the system obtains the asset price through the "constant product" model. The "constant product" model sounds complicated, but the actual principle is very simple, and it is the same as the behavior of the individual market maker described above - under the condition of a certain total capital, it ensures the balance of the stocks on both sides. Adjust prices if there is an imbalance. The difference is that market makers adjust the range of price changes based on their own judgment, while automated market-making models follow a fixed ratio.

Here comes the question, how does the change of the fixed ratio reflect the real market supply and demand? The key is arbitrage. After each transaction, due to the change of inventory, the model will assign a new price to the transaction asset. If the price deviates from the market price, there will be an arbitrage opportunity. Arbitrageurs can trade at the deviated price, and make up for the missing assets while obtaining the price difference. into the pool.

Uniswap is like a special vending machine. As long as someone buys a commodity, the price of the commodity will increase, and the more people take, the faster the price will soar[1] until market makers and arbitrageurs replenish the goods.

In other words, the Uniswap market-making process is actually participating in the crowdfunding of a special vending machine and sharing profits in real time.

Why?

Crowdfunding is not without risks. Market makers need to give up their position control over asset portfolios and let a constant algorithm change in market fluctuations. For example, suppose Alice invests 50% of ETH and 50% of Dai (USD stable currency) into the market-making fund pool to obtain 1% of the shares. One month later, the price of ETH plummets, and the market-making fund pool will close When a large amount of ETH is sold and a large amount of Dai is bought, the stock ratio of ETH and Dai in the fund pool changes to 80% and 20%. For Alice, the ratio of ETH and Dai that can be redeemed for 1% of her shares will no longer be half and half, but the ratio of 80%: 20% of the fund pool at this time. Alice passively increases the downside risk of ETH's price (50% -> 80%), and one month's fee income will most likely not be able to hedge the loss.

Compared with large supermarkets such as traditional exchanges, vending machines placed in public places are freely available to everyone, convenient and fast, and suitable for small transactions. The limitation is that the vending machine does not have the right to price the assets. Its price basically comes from the mirror image of the price of the centralized exchange, and relies on arbitrageurs to continuously inject funds to erase the premium.

In real life, we not only need vending machines to meet temporary needs, but also rely more on large supermarkets to meet the daily needs of the public. In the world of cryptocurrency, automated market-making DEX is an interesting part of DeFi Lego, but it cannot become mainstream.