#cpamm

Whilst the news has been around the collapse of FTX, a centralised exchange (CEX). In the DeFi world, decentralised exchanges (DEX) have been humming along and are a core component in making DeFi continue to work. 

Orderbook 

The very first DEX’s were order book based and designed to behave similarly to how traders use CEX. The process usually required users to transfer their tokens into a smart contract of the DEX platform, then they could create buy or sell orders on the chain.

The main issues where high fees and latency. Every transaction needed to pay Ethereum gas fees; depositing tokens, creating orders, cancelling orders and withdrawing tokens back to your wallet.

Since every transaction was reliant on the Ethereum network, it meant waiting for the transaction to be mined.. this could mean seconds. If the network was congested it could mean waiting minutes or paying much higher gas fees.

AMM (Automated Market Maker)

Uniswap launched the first version of the AMM towards the backend of 2018. This method removed the use of an order book using a constant product formula (linked for more details)

No matching is required,  the transaction is all on chain and it is easy to understand from a UX view. You input how many tokens you want to sell, what token you wish to receive and received a quote. The actual trade only takes one transaction (providing permission for the smart contract to use the tokens has been granted).

In terms of liquidity, users could become market makers by providing both tokens to the trading pool of relative value of each asset and receive fees for every single trade made. Balancer expanded this scope so that multi token pools could be used.

The biggest drawback to the first iteration of AMM’s is impermanent loss (IL). This is where the value of the tokens you supplied to the liquidity pool as a market maker, is worth less in total than if you had just held the tokens in your wallet after price fluctuations. This can happen if the fees generated as a market maker do not overcome the price changes.

Another drawback is because of the constant product formula, the trading liquidity is spread out across the entire possible price range of the tokens, which is inefficient in terms of price discovery and slippage (the difference between the expected price of a trade vs the actual price at execution)

Concentrated liquidity AMM

To overcome some of the drawbacks of the first iteration of AMM’s. Uniswap introduced concentrated liquidity in March 2021.

This allows users to provide liquidity within a concentrated price range, as opposed to the full range. This improves capital efficiency and enables more market making strategies, for example, in low volatility markets, concentrating liquidity in a small price range could maximise fees. However this can expose users to larger IL.

There have been iterations to this model, Kyberswap incorporates earned fees into the liquidity provision which acts as a form of autocompounding, and in Nov 2022, TraderJoe have launched their liquidity book which increases fees automatically at times of high price volatility, and enables users to concentrate liquidity using different patterns of token distribution across the price range.

What’s Next?