DeFi Observation: If the bear market comes, will AMM and liquidity mining be cold?

Editor of this issue | Colin Wu

Editor of this issue | Colin Wu

In this round of bull market, the combination of AMM and liquidity mining has set off a wave of DeFi, and various innovations have emerged one after another. But we must also see that its essence requires new tokens from liquidity mining to subsidize impermanent losses.

At present, there are views in the industry predicting that as the popularization of vaccines leads to monetary policy adjustments, the bear market may come as early as autumn. So at that time, can the AMM and liquidity mining that support the DeFi frenzy continue?

As the mainstream model of DEX, AMM (Automated Market Maker) is very popular because of its decentralization and "yield farming" (liquidity mining). However, its design itself has many flaws compared to the order book model used by traditional exchanges.

For market maker strategies in traditional exchanges, an excellent market maker strategy needs to meet two points: 1. It can complete enough trading volume. 2. Avoid inventory risk to the greatest extent, that is, impermanent loss in AMM.

The current market-making models such as Uniswap and Sushiswap are flawed, because Uniswap does not take advantage of the high volatility of encrypted assets to earn price differences like traditional market makers, and requires the intervention of arbitrageurs to make its prices consistent with centralized exchanges .

Such a design is more for the convenience of users to conduct transactions, but it loses the profits of LP (liquidity provider). Especially in the case of deducting liquidity mining rewards, if you only rely on earning fees, the income of most AMMs is very scary compared to the impermanent losses in the bear market.

Like Uniswap has canceled liquidity mining rewards, other automatic market makers like Sushiswap cannot always compensate LP's impermanent losses through liquidity mining. The impact of canceling liquidity mining may not be obvious in a bull market, because the risk of participating in market making is relatively small in a bull market. However, in a bear market, income from handling fees will inevitably decrease, and impermanent losses will increase exponentially in a bear market. LPs have many reasons to withdraw liquidity.

(In a bull market, even if LP’s currency increases five times, it only loses 25% compared to not participating in AMM; but in a bear market, LP’s losses increase exponentially)

For ordinary defi users like me, if we want to know the sustainability of doing LP in AMM, there are two questions that need to be answered: 1. If there is no liquidity mining, can we still generate enough income? 2. Compared with AMM, is the market-making strategy of traditional market makers better?

In essence, liquidity mining is an unsustainable reward, which can only compensate for the impermanent loss of LP in the short to medium term. For LPs, the only sustainable income comes from the handling fees generated by users using DEX. However, the dilemma of AMM is that if AMM stops liquidity mining rewards, it can easily lose TVL (Total Value Locked) or be attacked by vampires.

As a leading DEX, although Uniswap has canceled liquidity mining rewards, it is still profitable to earn handling fees alone. APY Vision shows an average fee of 53% over the past 30 days. But this does not mean that all AMMs are the same. In fact, even Uniswap lost a lot of liquidity in the short term after suspending liquidity mining rewards in November 2020. Not to mention the vampire attack completed by sushiswap in August last year. If it is sushiswap, because of its lower trading volume, its 30-day average income from handling fees is only about 15%.

Source: APY Vision

Although currently Uniswap can earn enough income only by handling fees, once it enters a bear market, the handling fees will be reduced, and with the exponential increase in impermanent losses, there is no reason for AMM's LPs not to withdraw liquidity.

The strategy of traditional market makers is completely different from the logic of automatic market makers like uniswap. For traditional market makers like Citidel and Jump Trading, their income mainly comes from "buying low and selling high" on assets to earn price differences, and traditional market makers will not be like LPs of automatic market makers when completing transactions Earn most of the commission, and even pay the commission.

Therefore, they care a lot about managing "inventory risk". For example, when making a market for BTC/USDT, like LPs in automatic market makers, traditional market makers will also prepare 50% of BTC and 50% of USDT, but traditional market makers will confirm that BTC is "reasonable" Price", and place an order at this "reasonable price" to buy low and sell high. If BTC suddenly drops sharply, traditional market makers will analyze the reasons for the drop and judge whether it will be lasting. If it is persistent, traditional market makers will stop buying low and start selling low to balance their inventory ratio. When the decline is over, traditional market makers will start to "buy low and sell high" again. At present, in the field of cryptocurrency, there are services like Humming bot that provide traditional market-making strategies for ordinary users, but their popularity is far less than that of automatic market makers.

The advantages of automatic market makers and traditional market makers are a bit like the pros and cons of a coin, which cannot be enjoyed at the same time. On the one hand, although automatic market makers cannot "withdraw" liquidity at any time when the market falls like traditional market makers, LPs can earn most of the handling fees and participate in liquidity mining. On the other hand, traditional market makers can more flexibly judge whether the current market situation is suitable for market making, which greatly reduces risks.

To put it simply, in a bull market, automatic market makers will bring higher returns to LPs than traditional market maker strategies; while in a bear market, traditional market makers’ market-making strategies will look much better than automatic market makers.