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The Evolution of Automated Market Makers and How They are Disrupting Traditional Finance

Are the Days of Traditional Market Makers Coming to an End?

DeFi Slate 📈

Oct 26, 2021

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DeFi Slate Fam:

After a whirlwind of a time in Lisbon this past week, were back in action with a post explaining the future of AMMs.

As a DeFi user you need to know what these automated market makers are capable of for you to earn yield and manage your risks.

Today we have a guest post from Hisham, Hisham Khan comes from a decade-long background in managing and building robust and innovative financial and enterprise technology and is now working on a top-notch AMM on Solana blockchain.

Enjoy!

-Andy

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The Evolution of Automated Market Makers and How They are Disrupting Traditional Finance

By Hisham Khan, CEO and Founder of Aldrin, written for DeFiSlate

Hisham Khan comes from a decade-long background in managing and building robust and innovative financial and enterprise technology. With an extensive career at Bloomberg, Hisham has worked as a project manager with some of the world’s top engineers. It was here where he discovered the transformative impact of cryptocurrencies, and has since left Bloomberg to build comprehensive trading tools through Aldrin. Built to be a trader’s all-inclusive digital trading companion, his mission is to make advanced crypto trading and strategy development accessible for all.

While the masses have traditionally relied on central institutions and leaders to govern political and financial decisions on the pretext of the greater good for the community, time has proven again and again that this is not an indomitable strategy.

With it being only human to error and be subject to temptation, it comes as no surprise that scandals continue to emerge on questionable decisions governing fiscal, financial, and even global policies.

Even a huge organisation such as the IMF, despite being backed by 190 countries to supposedly foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, has shown that it is not immune to fault, amidst accusations of potential bias by Chief Kristalina Georgieva.

With global organisations and those of established countries such as the U.S.A. struggling with decisions with huge ramifications, it is evident that consensus by a large majority of authority figures may not always result in the desired outcomes/ benefit the intended target groups.

One thing is for sure, however; members and followers of every community are always left to pick up the pieces, with the less wealthy bearing the brunt of the consequences, with their lack of financial resources leaving them much more vulnerable than the affluent.

Amidst this financial inequality, it comes as no surprise that a revolution is steadily growing, where individuals are choosing to take control of the governance and growth of their own assets, instead of relying on third parties, intermediaries or central institutions to do so.

In the past ruled by traditional financial practices, this would have been deemed an impossible and almost laughable notion, but with the rise and rapid advancements in Decentralised Finance (DeFi) infrastructure, smart contracts, and technology, this is not just a possibility but a reality.

Individuals can not only retain control over the growth of their own assets, but also have a multitude of choices as DeFi initiatives and offerings grow in depth and variety.

Unsurprisingly, regulators and central institutions have been attempting to curb this wave and trying to maintain the control and influence they have exerted in traditional finance (TradFi), with varying levels of success.

Ultimately, this is but a futile resistance, as investors and individuals become more educated about DeFi and grow in financial literacy. It is inevitable the community will seek to retain financial ownership and control, when various crises and recessions have proved that TradFi institutions prioritise self-interest over that of stakeholders, although it is also the resources of investors that are at risk.

Are the Days of Traditional Market Makers Coming to an End?

In the world of TradFi, stock exchanges are where stockbrokers and traders can buy and sell assets and securities (i.e. shares of stock, bonds, and other financial instruments). They may also provide facilities for issuing and redeeming such assets and capital events, including paying income and dividends.

Stock exchanges often function as "continuous auction" markets with buyers and sellers transacting via open outcry at a central location (i.e. the floor of the exchange) or by using an electronic trading platform.

While many academicians, scholars and economists debate on this point, the existence of stock markets could date as far back as Ancient Rome, where organisations of contractors or leaseholders who performed temple-building and other services for the government, held partes or shares, or in the form of the Amsterdam stock exchange. This paved the way for the large stock exchanges today.

The need for liquidity for these stock exchanges gave birth to market makers. Consisting of either individual participants or member firms of an exchange buying and selling securities for its own account, market makers are compensated for the risk of holding assets (as its value may diminish between purchase and sale to another buyer).

Market makers earn a profit through the spread between the asset bid and offer price. For example; when an investor sees that a particular stock has a bid price of $100 and an ask price of $100.20, this indicates the market maker has bought the shares for $100 and is selling them for $100.20, earning a profit of $0.20.

Brokerage houses are the most common types of TradFi market makers, providing purchase and sale solutions for investors. Housing some of the world’s most prestigious stock exchanges ( i.e. the NYSE and NASDAQ), Wall Street has become synonymous with the financial markets of the U.S.A and is often what comes to mind as the epitome of conventional trading around the world.

However, with the rise of DeFi, it is no longer a necessity to rely on brokers or traders, or even traditional stock exchanges and limit order books, with smart contracts and consistent advancements in the technology powering permissionless protocols that enable 24-7 peer-to-peer trading.

Mirroring the market makers in the world of traditional finance, Automated Market Makers (AMMs) were born out of the need to provide liquidity to exchanges in the DeFi ecosystem. They allow digital assets to be traded in a trustless and automatic way by using liquidity pools rather than a traditional market of buyers and sellers.

How Do AMMs Work and How Do They Differ From Traditional Market Makers?

AMM users supply liquidity pools with crypto tokens, whose prices are determined by a constant mathematical formula. Liquidity pools can be optimized for different purposes, and are proving to be an important instrument in the DeFi ecosystem.

Stemming from a blog post by Ethereum founder Vitalik Buterin, the basis of AMMs is a simple mathematical formula that can take many forms. The most common one was proposed by Vitalik as: tokenA_balance(p) *tokenB_balance(p) = k, which was then popularized by Uniswap as x * y = k.

On a Centralised Exchange platform (CEX), buyers and sellers offer up different prices for an asset. When other users find a listed price to be acceptable, they execute a trade and that price becomes the asset’s market price. Stocks, gold, real estate, and most other assets rely on this traditional market structure for trading. However, AMMs have a different approach to trading assets.

In CEXs, to provide liquidity for buyers and sellers, market makers provide the market with liquidity and depth while profiting from the difference in the bid-ask spread.

AMMs in contrast are decentralised, always available for trading, and do not rely on the traditional interaction between buyers and sellers. This new method of exchanging assets embodies the basis of DeFi, crypto, and blockchain technology in general: no one entity controls the system, and anyone can build new solutions and participate.

This has given rise to Decentralised Exchanges (DEX), which allow for direct peer-to-peer cryptocurrency transactions to take place online securely and without the need for an intermediary.

Aligning with the principles of DeFi, this allows for equality in financial opportunities, in the sense that investors are no longer encumbered by high-entry level banking policy requirements, or left at the mercy of intermediaries who make questionable decisions while prioritising their own incentives.

The gap between the wealthy and less well-to-do is also bridged, as DEXs are equally accessible to anyone with a cryptocurrency wallet. Individuals can make their own choices in governing their assets, instead of simply bearing the consequences of poorly structured fiscal policies which leave the poor more vulnerable and hardly affect the wealthy.

Unlike traditional market makers, AMMs are always available for trading via the usage of liquidity pools. A basic liquidity pool creates a market for a particular pair of assets on a DEX (i,e, DAI/ETH). When the pool is created, a liquidity provider sets the initial price and equal supply of both assets. This concept of an equal supply of both assets remains the same for all the other liquidity providers willing to supply liquidity to the pool.

Liquidity providers are incentivised in proportion to the amount of liquidity they supply to the liquidity pool. When the trade is facilitated, the transaction fee is proportionally distributed among all liquidity providers, and smart contracts govern what happens in the liquidity pool, where each asset swap facilitated by the smart contract results in a price adjustment.

This has also given birth to Yield Farming protocols such as Aave, Compound,Uniswap and Curve Finance where liquidity providers are also incentivised in the form of issuing of governance tokens, interest from lenders who borrow tokens from the pool, aside from the transaction fees of trades.

In contrast to TradFi stock exchanges, DEXs facilitate the exchange of assets easily, without creating any accounts and trusting funds to third parties. Users are thus able to maintain anonymity and control over their assets in their Crypto wallet, making them less vulnerable to hacks in CEXs and embezzlement or accounting fraud in TradFi.

However, no one thing is absolutely perfect, and the liquidity pools that drive AMMs are not without their own downsides.

Impermanent losses are one of the risks of liquidity pools. It results in a loss of funds by liquidity providers because of volatility in a trading pair of assets, either from the imbalance in the ratio or the value of the assets themselves.

However, the bigger the liquidity pool in proportion to trade, the smaller the difference between the expected price at which the trade is executed. This price difference is called slippage. Since larger liquidity pools can accommodate more significant trades they create less slippage, which results in a better trading experience, which can be seen from more established DEXs like Curve, UniSwap and SushiSwap.

Additionally, as in any decentralised platform, smart contracts are subject to bugs, failure, hacks, or exploits, which is why it is important for the underlying code to be audited to improve security and reduce risk.

The Evolution and Growth of AMMs, DEXs and the Opportunity to Revolutionize Finance Through DeFi

While CEXs such as Binance and Coinbase play important roles as the bridge between crypto and fiat currency and provide traders with convenience, the growth of AMMs has also resulted in the rise in the adoption of DEXs.

As AMMs reduce the dependence on external market makers to provide liquidity and the need for centralised order books, DEXs have grown in popularity for traders and investors.

As DEXs are non-custodial, not subject to financial regulation, and do not require you to reveal your identity, unlike CEXs which require identity verification (i,e, through KYC/AML policies) and place your personal data and funds at risk from hacks, traders will also have more control over their own assets/funds.

There is also a paradigm shift among the DEXs themselves. While established DEXs like Curve, UniSwap, and SushiSwap provide traders a reduced level of risk from the larger liquidity pools compared to newer AMMs with low TVL, transaction speeds and high gas fees of the Ethereum blockchain serve as limiting factors.

With Ethereum’s current consensus protocol being based on the Proof of Work model, it allows for only transaction speeds of 13 per second, as compared to the 1.34 million transactions per day, resulting in scalability issues.

While Ethereum is transitioning to its proposed Proof of Stake model in a year for much-needed improvements, this has given room for many competitors such as Binance Smart Chain, Solana, Polkadot, Polygon which rival it in performance, speed, and scalability.

Solana is notably touted as an Ethereum killer for its ability to handle 50,000 transactions per second, making it at least 3000 times faster than Ethereum, making AMMs and DEXs on the Solana blockchain much more responsive, meaning traders are able to transact faster and in a more accurate manner, reducing the likelihood of price slippage and high gas/transaction fees.

This has propelled AMMs such as Orca and Raydium which run on the Solana blockchain to the forefront. Due to Solana being relatively young as a protocol, there still exist security risks from
the lack of firms able to audit its code, resulting in scarcity and long lead time for fully audited running on the blockchain.

As the first 3rd party audited AMM on the Solana blockchain, Aldrin will be able to provide the same benefits to traders/investors as other Solana DEXs, but with more security. Additionally, its uncomplicated interface with tools such as Rebalancer make it easy to use even for newer investors with a passive trading strategy. Being fully audited by top cybersecurity firm Kudelski Security marks an important milestone in a move to bring the Solana blockchain and DeFi, to a level of institutional-grade security parallel with that of traditional financial infrastructure

While this does not indicate the obsolescence of traditional financial exchanges, it definitely signals the growth of DEXs and AMMs as strong alternatives to TradFi stock exchanges and traditional market makers.

As DEXs and AMMs become more robust and reliable, both individuals and investors will embrace the ability to take direct control over the trading of their own assets and freedom to execute transactions/trades on a 24-7 basis.

Although newcomers unfamiliar with blockchain and DeFi technology will continue to explore traditional money markets first, the promise of freedom to govern one’s own assets will inevitably attract investors to experiment with DEXs and AMMs, as security and infrastructure for DeFi and blockchain continues to improve.

A future where traditional stockbrokers and market makers being rendered completely pointless may not be set in stone, but a world where TradFi Stock exchanges and money markets have to acknowledge the DeFi Ecosystem and its various alternatives in DEXs and AMMS as equally viable options for traders and investors is inevitable. The only question is not if it is possible, but when.

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⚠️ DISCLAIMER: Investing into cryptocurrency and DeFi platforms comes with inherent risk including technical risk, human error, platform failure and more. At certain points throughout this post, we might get commission for promoting certain projects, if this is the case we will always make sure it is clear. We are strictly an educational content platform, nothing we offer is financial advice. We are not professionals or licensed advisors.

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