Automated market makers are dead

Billions of dollars poured into decentralized exchange protocols based on the Automated Market Maker (AMM) model, which initiates network effects by inducing liquidity with project tokens, creating a self-sustaining ecosystem of traders. and yield producers.

This mechanism allowed decentralized exchanges (DEX) to compete for the first time with centralized counterparts, such as Coinbase, which can afford to use cash from their balance sheets to pay for user acquisition (for example, via registration and referral bonuses). As a result, AMMs have been hailed as the cornerstone of Decentralized Finance (DeFi), spawning multiple permutations and triggering the trend towards yield farming that has helped lure billions of US dollars into smart contracts.

Related: The rise of DEX robots: AMMs push for an industrial revolution in trading

But lingering under this supposedly solid foundation of this DEX model is a dirty little secret that could be its demise.

The fall of marketing authorizations

AMMs reduce the market-making mechanism of crypto assets to the simplest possible financial primitive: two pools of liquidity are coupled with an exchange rate that naturally adjusts according to relative demand – almost like a former trader is holding between two piles of grain and beans, swapping one for the other on demand.

The sheer ineffectiveness of this model means that the main beneficiaries are not the liquidity providers or the traders using the network, but the arbitrageurs:

• Traders suffer from high gasoline costs and poor execution. AMMs are siled from each other and have little or no interoperability, forcing traders looking for deep liquidity to deploy funds on different protocols and blockchains or suffer slippages and partial fillings.

• Liquidity providers passively sell tokens with rising exchange rates and buy tokens with falling rates, creating an impermanent loss when the value of a digital asset drops after it is purchased from a seller before it is sold to a buyer. Thus, unlike market makers active on order book exchanges, they can lose out in the face of regular market movements.

• Arbitrators, on the other hand, can step in and buy cheap assets until the pool price is properly valued.

The developers have attempted to correct these problems; fine-tune settings and introduce new features such as temporary loss insurance and third-party interfaces for transaction management. Yet they have met with limited success. Impermanent loss is built in – it cannot be completely eliminated, only passed on to other protocol participants who manage the risk by sharing the profits and losses.

Ultimately, the only way to ensure that liquidity providers on MAs are consistently profitable is to counter losses with strong incentives in the form of newly created tokens.

When buyers disappear at the end of the wave of speculation around a new project, the inevitable selling pressure then pulls token prices down, forcing liquidity providers to pack their bags and switch to more profitable protocols. and freshly launched. Anyone who holds a governance token will likely only vote for maximum short-term financial gain – to the detriment of the protocol.

Related: Yield farming is a fad, but DeFi promises to change the way we interact with money

The rise of middleware

Over time, the AMM model is threatened by another intrinsic limitation of blockchain: the lack of interoperability.

The return-generating activity stimulated by token incentives exceeds the scalability of the underlying blockchains. This increases fees and delays transactions, leading liquidity providers to AMMs running on new side chains, layers two and next generation layers.

Yet every new blockchain is an island. Moving funds between chains, especially between the two isolated layers, can mean having to go back to the homeland of the original first layer and then make another jump to the final destination. Along the way, the yield farmers’ crops are depleted by underlying blockchain fees and delayed by long integration queues – not to mention the headache of tracking funds to different places.

Related: Professional traders need a global crypto sea, not hundreds of lakes

In this rapidly emerging multi-chain future, middleware chains have a great opportunity to become the first port of call for liquidity.

Interoperable middleware can confidently interact with different chains to define the most efficient trading routes across multiple sources of liquidity, be it Uniswap pools or limit order book DEXs like Serum. That way all the fun of the fair – the same rides and attractions of the first layer chains – can be available, but without the transaction delays, high fees, and interoperability silos. For the end user, the underlying protocols or platforms providing liquidity are simply mined through a single user interface, in the same way cryptographic standards such as “HTTPS” are mined on the Internet.

Related: Is Crypto Approaching Its ‘Netscape Moment’?

User-centric tokenomics

Without any of the inherent limitations of AMMs, layer two middleware chains are better positioned to generate value and create lasting crypto economies that reward all users.

This means going beyond the incentive structures that power Layer 1 blockchains, beyond the 2017 “utility” and “security” tokens, and beyond DeFi governance tokens.

Related: Life Beyond Ethereum: What Layer 1 Blockchains Bring To DeFi

New tokenomic models are needed that not only reward liquidity providers and validators, but motivate all users of a network to generate real long-term network value. With this in place, not only will traders flock to middleware to save on fees and get better execution, developers will follow suit to build DeFi applications that can directly leverage the efficiency of Layer Two, and vendors. of liquidity will come for the most lucrative pay.

Suddenly, the liquidity wars raging between the AMMs on the underlying channels will be fought on a new battlefield.

This article does not contain any investment advice or recommendations. Every investment and trading move involves risk, and readers should do their own research before making a decision.

The views, thoughts and opinions expressed here are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.