In the last episode, we deep-dived into order book exchanges. Our takeaway: it’s a flexible and efficient model but only works with a limited set of assets. In this article, we will examine how AMMs overcame order book exchanges’ limitations to enable on-chain trading. 🤩

AMMs: inclusive but inefficient

Definition

Automated Market Makers (AMMs) are recent: they only appeared in 2017. AMMs automate the process of providing liquidity and exchanging assets through smart contracts.

Instead of pricing assets through an Order Book, AMMs use a simple formula based on asset quantities in the pool. This is a major innovation because trading can now take place without any intermediary other than the code.

Key advantages

First advantage: any asset can be freely brought to the pool. Projects can launch their own token and easily list it, making it more accessible and liquid for users. They don’t need to wait for approval by a centralized authority, or to pay fees to market makers. Thus, fees for token emission and management are drastically reduced. This helped fuel the development of the DAO ecosystem!

Furthermore, there is no need to trust a centralized exchange with the custody: the pool interacts directly with the user’s wallet. No more fear of hacks when trading your assets!

Finally, anyone can provide liquidity to the pool and therefore earn fees based on trading activity. The people now have access to market-making strategies that were previously reserved for sophisticated investors, such as Citadel Securities in TradFi.

Key disadvantages

Price discovery and quantity updates are costly. Whenever the price of an asset changes on an exchange like Coinbase, the pool’s prices are not affected. Only arbitrage traders can update asset prices and quantities in the pool, at the expense of Liquidity Providers (LPs) and retail traders.

This results in Impermanent Loss (IL), a phenomenon through which Liquidity Providers are worse off when investing in the pool relative to a HODL strategy. IL is costing LPs billions of dollars a year. An academic study recently estimated that 50% of Uniswap v3 users are losing money by committing their liquidity to pools.

Traders are also losing out because of Impermanent Loss. To prevent LPs from quitting, AMMs need to compensate for LP’s impermanent loss by increasing APYs. A move that is often financed by raising fees for traders.

Check the following tool https://amm.vav.me/ if you want to compare the performances of various Uniswap pools, including Impermanent Loss.

Conclusion

AMMs enabled on-chain trading at the expense of LPs and traders, who are losing out large sums due to Impermanent Loss. Making on-chain trading sustainable requires a better solution. That’s what we are going to see in part 3 of this article series!

*This is the second part of a 3-piece story on AMM vs.Order Book. Stay tuned for the third episode! *😉