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The change from 0 to 1, one article to understand AMM automatic market maker



Since the beginning of this year, the popularity of Defi has continued to heat up, and the decentralized exchange DEX, which is an important part of Defi, has also continued to receive attention. As a typical DEX, the AMM automatic market maker has created a precedent for financial asset transactions that do not rely on order books, and is a 0-to-1 transformation of financial transactions. This article briefly describes several different models of exchanges from centralized exchanges to DEXs and then to AMMs. The second part analyzes the characteristics of the four pricing models of AMMs. The third part expounds the inherent problems of AMMs and Finally, the development prospect of AMM is prospected. In the Netherlands in the 16th century, due to the rapid development of maritime trade and industry and commerce, merchants’ demand for financing increased day by day, so the world’s first financial stock exchange was born in Amsterdam, and the Amsterdam Stock Exchange laid the foundation for the development of securities trading. It has a profound impact on the trading model for hundreds of years. The stock exchange merged with the Paris Stock Exchange and the Brussels Stock Exchange in September 2000 to form the world's first cross-border pan-European exchange. Whether it is stock trading or digital asset trading, there are currently two main trading systems in centralized exchanges: bidding trading system and market maker system. The bidding trading system is also called the entrustment-driven system, and its characteristic is that the opening price is formed by call bidding, and then the trading system sorts the incoming trading orders of investors according to the principle of price priority and time priority, and matches the buying and selling orders to bid for a deal. The market maker system is a legal person with certain strength and reputation acting as a market maker, continuously providing investors with buying and selling prices, and accepting investors' buying and selling requirements according to the prices provided, and using its own funds and securities to communicate with investors. Conduct transactions to provide immediacy and liquidity to the market, and achieve a certain profit through the bid-ask spread. Simply put, it is: quote a price, and buyers and sellers can buy or sell at this price without waiting for the counterparty to appear. BitMEX has launched the FLRUSDTH23 futures contract: On December 15th, according to official news, BitMEX announced that it has launched the FLRUSDTH23 futures contract and started trading. It is reported that Flare Token (FLR) is the native asset of the blockchain project Flare Network. [2022/12/15 21:46:33] From the above, we can see that whether it is the bidding system or the market maker system, the conclusion of the transaction is guided by the buying and selling quotation as a signal. Only when there is an intersection between the bid price and the bid price, that is, the price that is most beneficial to both parties in the transaction is matched in the order book, the transaction will take place. The advantage of a centralized exchange is that it has a large number of users, a large transaction volume, and good liquidity, so that the transaction matching efficiency is high, the real-time performance is strong, and the user experience is good; the disadvantage is that since it is centralized, there is a single point of failure SPOF, Whether it is man-made moral hazards, operational risks, or technical hacker attacks, the security of users' funds will be threatened. Such cases have emerged endlessly in the past few years, such as the famous Mentougou incident. Decentralized exchange (DEX, Decentralized Exchange) is an important part of Defi (Decentralized Finance). The functional advantage is that users usually do not need to provide detailed personal information, that is, no KYC is required, and the anonymity is good. At the same time, the exchange can Avoid policy constraints (decentralization, cannot be closed at a single point); but currently there are defects such as poor user experience, incomplete functions and low transaction volume. Serum is now unavailable because it cannot be upgraded to deal with security risks. The official recommendation is that the community turn to forked versions such as Openbook: On November 29th, Serum, a Solana-based DeFi project, tweeted: "With the collapse of Alameda and FTX, the main The Serum program on the Internet is no longer valid. Since FTX has escalation rights, security is at risk, leading to the removal of protocols such as Jupiter Aggregator and Raydium from Serum, however, there is still hope. Under the leadership of Mango Max, the entire community is Efforts to fork Serum.” The official said that the future of SRM tokens is uncertain, due to the exposure of FTX/Alameda, some members of the community suggested that it should still be used for discounts, and some members suggested not to use the token at all. Serum said: "OpenBook, a forked version of the community-led Serum V3 program, is currently live on the Solana mainnet, and further efforts are being made to expand the project and its liquidity. This means that with the existence of Openbook, Serum's transaction volume and liquidity has dropped to close to zero. After discovering the security risks of the old Serum code, users and protocols can safely use alternative forked versions, such as Openbook.” It is reported that Sam Bankman-Fried, the former CEO of FTX, is the co-founder of Serum . [2022/11/29 21:09:34] In 2020, AMM (Automated Market Maker) represented by Uniswap was born. AMM is a kind of decentralized exchange, which is different from centralized exchanges and Unlike most decentralized exchanges, AMM does not rely on order books, the price of assets in AMM is determined by a function, and the market is jointly maintained and operated by traders, liquidity providers and arbitrageurs. According to different constant functions, common AMMs can be divided into four types: constant product market maker (CPMM), constant sum market maker (CSMM), constant mean market maker (CMMM) and mixed constant function market maker ( CFMM). Different function market makers have different pricing logics and have their own advantages and disadvantages, which will be analyzed in detail below. Investment banks are expecting the Fed to raise interest rates sharply in September: September 10 news, Deutsche Bank economists said in a report on Friday, "The Fed's recent speech is very hawkish, and the upcoming data is expected to be unable to stop Officials are on another aggressive hike, and we expect the Fed to raise rates for the third time by 75 basis points." The previous estimate was for a 0.5 percentage point increase. Now, a growing number of economists see a 75 basis point rate hike as the likely outcome. Analysts at Bank of America, Barclays and Jefferies adjusted their expectations for a 50 basis point rate hike by the Fed to a big hike after Fed Chairman Jerome Powell's speech on Thursday. Economists at Goldman Sachs Group Inc. made the same adjustment late Wednesday. [2022/9/10 13:20:32] CPMM (Constant Product Market Maker) is a constant product market maker. Typical exchanges include Uniswap and Bancor. The principle of CPMM is to price digital assets through the function X*Y=K. X and Y respectively represent the quantity of two different digital assets A and B in the fund pool, and K represents a constant. This function is based on the available quantity of each token (Liquidity) Determine the price range of the two tokens. X and Y are a trading pair. When the supply of token A increases, the supply of token B must decrease, and vice versa, to maintain a constant product K. When plotting this function, the result is a hyperbola where liquidity is always available but prices get higher and higher, approaching infinity at both ends. When the supply of token A is very large, a small amount of token B can be exchanged for a large amount of token A. Although this balance is established in the CPMM model, after breaking away from this system, token A and token The market price of B may not be as shown in the CPMM system, so there will be opportunities for arbitrage. Arbitrageurs will exchange a large amount of token B for a large amount of token A, so that the supply and demand relationship between the two tokens will be restored to balance. The transaction volume of MiningverseNFT Official surged by more than 36000% in the past 24 hours, and the transaction volume ranked first in OpenSea: Golden Finance News, according to OpenSea data, as of press time, the transaction volume of MiningverseNFT Official in the past 24 hours was 775.59ETH, and the transaction volume in the past 24 hours has increased 36832.93%. The current transaction volume ranks first in OpenSea. [2022/7/24 2:34:41] Figure 1. CPMM Asset Pricing Model Source: DmitriyBerenzon CSMM (Constant Sum Market Maker) is a constant and market maker, ideal for zero slippage, but cannot provide unlimited liquidity. The pricing model of constant and market makers is X+Y=K, and K is a constant. In this model, the exchange relationship between X and Y is always 1:1, so there will be one asset that is fully exchanged by another asset In the event of exhaustion, liquidity is lost. This situation would destroy one side of the liquidity pool, forcing liquidity providers to suffer losses, and making traders no longer liquid. Therefore, Constant Sum Market Maker (CSMM) is not a common AMM model. The game guild YGG announced a cooperation with the game-specific blockchain project Oasys: On February 9th, the game guild YGG announced a cooperation with the game-specific blockchain project Oasys, and YGG will become one of the validator nodes on the Oasys chain. As previously reported, Oasys was jointly launched by the Japanese game company Bandai Namco and Sega. It adopts a proof-of-stake consensus mechanism. It will provide transaction services for projects considering issuing and selling NFTs without charging users. [2022/2/9 9:40:13] Figure 2. Source of asset pricing model of CSMM: Dmitriy BerenzonCMMM (Constant Mean Market Maker) constant average market maker, which allows the creation of more than two tokens, and in AMMs weighted outside the standard 50/50 distribution. In this model, the weighted geometric mean of each reserve asset remains constant. For a liquidity pool with three assets, its formula is as follows: (X*Y*Z)^(⅓)=K. For the trading pair of two tokens, whether it is CPMM or CSMM, there are inherent disadvantages. Although CPMM can provide permanent liquidity, the transaction slippage will be more obvious. Although CSMM is an ideal choice for zero slippage, it cannot Provide unlimited liquidity, so the hybrid CFMM model that combines the advantages of the two appears. CFMM (Constant Function Market Maker) is a hybrid constant function market maker that combines a variety of functions and parameters to achieve specific behaviors, such as adjusting the risk exposure of liquidity providers or reducing price slippage for traders. As shown in Figure 3, Curve AMM combines the advantages of both CPMM and CSMM. Within a given range, X and Y follow CSMM, so that slippage will be reduced during the transaction process. When the supply of X or Y increases significantly or When decreasing, the price relationship between X and Y follows CPMM to ensure the existence of liquidity. Figure 3. Hybrid CFMM Pricing Model Source: Curve White Paper Three Inherent Problems of AMM and Improvement Solutions The main factors hindering the development of AMM are impermanent loss (Impermanent Loss), multi-token exposure risk and low capital efficiency. The impermanent loss IL refers to the difference in value between liquidity providers depositing tokens in the AMM and simply depositing tokens in the wallet. The reason for the impermanent loss is mainly because when the market price of a certain token changes, the price change cannot be reflected in the AMM system in time, and arbitrageurs sell overvalued tokens or buy bottoms of undervalued tokens, making The interests of liquidity providers are damaged. When the price of the token returns to the market price in the AMM, arbitrageurs will no longer arbitrage through buying and selling, so that impermanent losses will stop in time. In the model designed by AMM, the price of tokens is automatically calculated based on the proportion of circulation and the established function model, which cannot reflect the market price of tokens in time, so there will be arbitrageurs. So if the price of tokens in AMM is anchored to its market price, will there be no interest rate difference, thereby reducing impermanent losses? The answer is yes. In order to make the price of tokens in AMM closer to its market price in a timely manner, an oracle (Oracle) was born in the Defi field. Rather than arbitrageurs fixing the exchange rate, the oracle provides pricing updates to adjust the weights of the AMM so that the internal exchange rate matches the external market price. The benefit of this is that arbitrageurs no longer take value away from liquidity providers in the form of impermanent losses. When the liquidity provider LP provides tokens to the asset pool, in order to maintain better liquidity of tokens, AMM generally requires LP to inject two different tokens into the asset pool at the same time. Therefore, liquidity providers (LPs) cannot maintain their long-term exposure to a single token, but must divide their exposure by holding additional ERC20 reserve assets. In order to solve the problem of multiple exposures, we can start from two aspects. On the one hand, it can increase the trading pairs between a certain token and other tokens, so as to give liquidity providers more flexible token allocation; on the other hand, the liquidity reserve can be anchored through the Chainlink oracle machine, and the bilateral liquidity deposit requirement can be canceled. There is a paradox in the AMM model, AMM needs a lot of liquidity to reach the same level as an order book-based exchange, only when the pricing curve changes exponentially, the liquidity in the AMM will be mobilized, and when the pricing curve When the index changes, there is often a large slippage in the price of the token, and this part of the liquidity rational traders will not use it. Therefore, due to the impact of slippage, most of the liquidity in the AMM model will not be used, resulting in lower capital efficiency. In the hybrid CFMM model, since the liquidity and slippage problems are well balanced, the liquidity of AMM can be developed to a greater extent and capital efficiency can be improved while ensuring a low slippage level. Figure 4 compares several mainstream AMMs from multiple perspectives. Figure 4. Comparison of several mainstream AMMs Source: IOSG Ventures First, AMMs price assets through a constant function model, which is a kind of minimalism. For example, Uniswap has only about 300 lines of code, which means low complexity and easy access to hackers The attack surface area is low, and the integration cost is low. Compared with traditional centralized exchanges, it has higher security and lower operating costs. Secondly, the AMM automatic market maker has created a trading model that does not depend on the order book, and investors can be less affected by market sentiment when buying and selling.


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