Automated market maker is dead

Billions of dollars flowed in based on Automatic market maker (AMM) model, which guides network effects by using project tokens to incentivize liquidity, thereby creating an independent ecosystem composed of traders and beneficiaries.

This mechanism enables decentralized exchanges (DEX) to compete with centralized exchanges for the first time, such as Coinbase, which can use cash on the balance sheet to pay user acquisition fees (for example, through registration and referral bonuses). As a result, AMM is hailed as the cornerstone of decentralized finance (DeFi), which has spawned a variety of permutations and triggered the trend of income agriculture, helping to introduce billions of dollars into smart contracts.

related: The rise of DEX robots: AMM promotes the industrial revolution in the trading field

However, what lingers under this so-called solid foundation of this DEX model is a dirty little secret that may die.

The decline of AMM

AMM simplifies the market-making mechanism of encrypted assets to the simplest financial primitive: two liquidity pools combined with exchange rates that are naturally adjusted according to relative demand-almost like an ancient merchant standing between two piles of grains and beans , Exchange one for the other requirements.

The absolute inefficiency of this model means that the biggest beneficiaries are not liquidity providers or traders who use the network, but arbitrageurs:

• Traders suffer from high gas fees and poor execution. AMM is isolated from each other and has almost no interoperability, forcing traders seeking deep liquidity to deploy funds on different protocols and blockchains, or encounter slippage and partial filling.

• Liquidity providers passively sell tokens with an increase in the exchange rate and buy tokens with a decline in the exchange rate. When the value of the digital asset drops after being purchased from the seller, and then sold to the buyer, it will cause impermanent losses. Therefore, unlike market makers who are active in order book exchanges, they may lose out to regular market volatility.

• At the same time, arbitrageurs can step in and buy cheap assets until the pool is priced correctly.

Developers have tried to fix these problems; adjust parameters and introduce new features, such as non-permanent loss insurance and third-party interfaces for managing transactions. However, their success has been limited. Permanent loss is built-in-it cannot be completely eliminated and can only be passed on to other protocol participants, who manage risk by sharing profits and losses.

Finally, the only way to ensure continued profitability of liquidity providers on AMM is to offset losses through massive incentives in the form of newly created tokens.

When buyers disappear when the speculative wave surrounding new projects ends, the inevitable selling pressure will drive down token prices, causing liquidity providers to pack up and switch to new, more profitable agreements. Anyone who holds governance tokens may vote for the largest short-term financial gain-which is not good for the agreement.

related: Yield agriculture is a fashion, but DeFi is expected to change the way we interact with money

The rise of middleware

Over time, the AMM model is being threatened by another inherent blockchain limitation: Lack of interoperability.

The revenue activities stimulated by token incentives exceed the scalability of the underlying blockchain. This will push up fees and delay transactions, pushing liquidity providers to switch to AMM running on new sidechains, second and next-generation layers.

However, every new blockchain is an island. Moving funds between chains, especially between isolated second tiers, may mean being forced to return to the original first tier homes and then jump again to the final destination. In the process, the harvests of high-yield farmers are exhausted by potential blockchain costs and delayed by long entry queues—not to mention the headache of tracking funds in different locations.

related: Professional traders need a global crypto ocean, not hundreds of lakes

In this fast dawning multi-chain future, the middleware chain has a great opportunity to become the first stop of liquidity.

Interoperable middleware can interact trustlessly with different chains to determine the most effective transaction route across multiple liquidity sources-whether it comes from the Uniswap pool or a central limit order book DEX like Serum. In this way, all the fun of the expo-the same rides and attractions as the first-level chain-can be used, but there are no transaction delays, high fees, and islands of interoperability. For end users, the underlying protocol or platform that provides liquidity is only abstracted through a single user interface, similar to the way that encryption standards such as “HTTPS” are abstracted on the Internet.

related: Is encryption approaching its “Netscape moment”?

User-centric token economics

Without any inherent limitations of AMM, the second-tier middleware chain can better accumulate value and create a sustainable encryption economy to reward all users.

This means going beyond the incentive structure that powers the first-tier blockchain, beyond the “utility” and “safe” tokens in 2017, and beyond the governance token of DeFi.

related: Beyond the life of Ethereum: What does the first layer of blockchain bring to DeFi

A new token model is needed, not only to reward liquidity providers and validators, but also to incentivize all users on the network to generate real long-term network value. With this, traders will not only flock to middleware to save costs and get the best execution, but also developers will follow to build DeFi applications that can directly use the second layer of efficiency, and liquidity providers will come to seek the most lucrative remuneration.

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

This article does not contain investment advice or recommendations. Every investment and trading action involves risks, and readers should research on their own when making a decision.

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