One of the most significant advances of decentralized finance (DeFi) has been the evolution of decentralized exchanges (DEXes) along with automated market makers (AMMs). These decentralized protocols have turned passive savers into Liquidity Providers (LPs) for trading activities.
Traditional market makers (MMs) provide liquidity in centralized exchanges by posting bids and offers and dynamically managing their sizes and prices using complex mathematical models. This is a highly specialized activity reserved only for sophisticated players.
A more appropriate term for market makers is ‘price makers’ since they create ‘prices’ by showing bids and offers in the market. Traders that simply buy or sell at the bids and offers available in markets are termed ‘price takers’ as they simply take the prices provided to them by price makers. Price makers have to deploy capital in order to provide liquidity and they earn a return on this capital in the form of trading spreads when price takers trade against them. They buy at bids and sell at offer and theoretically pocket the difference.
AMMs allow passive savers to become LPs. Passive LPs provide the capital and get a return from trading fees without worrying about managing their positions actively. AMMs replace the sophisticated price making process of traditional AMMs with (relatively) simple mathematical frameworks that are based on the inventory of tokens in liquidity pools. This means passive LPs can leave assets in these liquidity pools and enjoy returns from market making activities that were earlier exclusively available to active market makers. This has created a new venue where investors can deploy their assets and earn a yield. This also means traders can enjoy abundant liquidity as more capital is deployed in liquidity provisioning activities.
Limitations of Current AMMs
The current crop of AMMs is still way too simplistic when compared to their traditional market making cousins. The most popular form of AMM is the constant product market maker (CPMM), which arrives at ‘fair’ market prices by keeping the product of token inventory balances constant. It relies on arbitrageurs to step in and correct price misalignments with the broader market. In the process a lot of potential profits for passive LPs is left on the table. Sophisticated LPs that provide liquidity to AMMs do a lot of heavy lifting in the form of inventory management off-chain.
One big issue stopping AMMs from evolving closer to traditional MMs is the gas bottlenecks for performing sophisticated calculations on-chain. The entire market making framework and intelligence needs to be done on-chain so that passive LPs can enjoy similar returns to traditional MMs.
Another big issue is the constant fee model that AMMs deploy. AMMs have volatility exposure and the fees should be tied to the level of volatility in the market. When markets are moving a lot, LP profits are eroded away by higher impermanent loss. Sophisticated LPs that dynamically rebalance their token inventories bleed more money doing these rebalancings in volatile markets. Conversely, AMMs accumulate profits in calm markets when there is trading activity around a stable price. Constant fee fails to reflect these market dynamics. This means LPs will be more inclined to take away liquidity from AMMs in volatile markets thus exacerbating market moves. In stable times, traders will be less inclined to pay the high fees on DEXes. This is the exact opposite of the desired dynamic! Volatility sensitive pricing is needed for incentivising LPs to keep funds during volatile times and traders to continue using DEXes in stable times. LPs should earn higher fees in turbulent times and lower fees in calmer markets. This would lead to a fairer and a more robust trading ecosystem.
The HMM Vision
Hydra Market Maker’s (HMM) vision is to create an AMM that is on par with the performance of traditional MMs. HydraSwap runs on the lightning-fast Solana chain, which removes the computational and gas cost bottlenecks facing AMMs on EVM-based (Ethereum virtual machine) chains. HMM would be the first to utilize the full technical capabilities of Solana to provide a high performance AMM with significantly improved LP returns and a more reliable trading framework.
Under the current constant product market maker (CPMM) model, passive market makers are beholden to a basic pricing mechanism. In its first version, HMM introduces a smarter pricing mechanism for incentivizing arbitrageurs while protecting the P&L of LPs and improving their impermanent loss profile. Improving the performance of LPs would attract more liquidity. This would lead to traders enjoying greater liquidity, greater depth, more reliable trading during volatile periods, and reduced slippage. Subsequent versions will add volatility sensitive pricing and style price bands.
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