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AMMs

An automated market maker (AMM) is a specific type of decentralized exchange (DEX) that relies on a mathematical formula to price assets instead of an order book where buys and sells are matched like on Coinbase or Gemini. Traditional market-making utilizes giant firms with extensive resources to create a tight bid-ask spread on an order book exchange. Automated market makers decentralize this process, enabling anyone to create a market for any two tokens on a blockchain. 

DEX vs CEX. Image credit: Wharton

The image shown below illustrates the three primary parties:

• Liquidity Providers – create new pools, add liquidity to existing pools, and remove tokens from reserves they contribute to;
• Traders – pay the swap fee, which is effectively added to the reserve of the pool KNC/USDT; and
• Arbitrageurs – enforce an efficient price mechanism at a pool-level.

Uniswap. Uniswap Blog​​​​​​

In order to enable anyone to provide liquidity and earn fees on any assets, Uniswap uses a mathematical formula to rebalance liquidity providers' deposits. Uniswap uses the formula x * y = k. 

• x is the amount of one token in the liquidity pool
• y is the amount of another
• k is a fixed constant 

Source

Both x and y are rebalanced based on their price and liquidity variations to one another. The goal is for the value of k to remain constant despite these changes and split 50/50 between both assets in the pool. Essentially, the ratio of value between the two tokens must always remain the same. The price of a trade is determined by how much the ratio between the tokens in the liquidity pool changes after a trade. If the ratio changes by a wide margin, there’s going to be a large amount of slippage.

Traders interact with a smart contract rather than an order book that dictates the trade price between assets. This is a peer-to-contract (P2C) interaction that removes the need for a central entity/business to help facilitate the trade. The combination of x*y=k and only interacting with smart contracts is what is truly revolutionary and enables Uniswap to democratize market making. 

Liquidity providers (LPs) add funds to the AMM pool, which creates the market for each trading pair. LPs will deposit an equivalent value of two tokens i.e 50% ETH and 50% AAVE to the ETH/AAVE pool. When a trader draws from that liquidity pool, the mathematical formula will set the price so that the balance of ETH-AAVE remains in balance.

Source

AMM Challenges

1. Liquidity: DEXs often face challenges in attracting sufficient liquidity. Liquidity fragmentation across various DEXs leads to higher slippage and limited trading options.

2. Impermanent Loss: Impermanent loss is the difference in value over time between depositing tokens in an AMM versus simply holding those tokens in a wallet. This loss occurs when the market-wide price of tokens inside an AMM diverges in any direction. Several solutions have attempted to address this issue, but none have gained solid traction so far.

3. Low Capital Efficiency: Traditional AMM designs require large amounts of liquidity to achieve the same level of price impact as an order book-based exchange.

4. Transaction Speed: The transaction throughput of most DEXs is limited by the underlying blockchain's scalability. Block confirmation times and network congestion can result in slower trade execution and higher gas fees.

5. Slippage: Slippage is the difference between the expected price of an order and the price when the order actually executes. It depends on the volatility of the underlying asset as well as the liquidity deployed in the pertaining Liquidity Pool (LP).

6. Front Running: Front running is an attack where a malicious user observes a swap transaction after it is broadcast but before it is finalized and reorders transactions to benefit themselves.

The DEX Trilemma

The two most important success indicators for DEXs are Total Value Locked (TVL) and Volume, but these are not necessarily the best metrics.

1. TVL: TVL often includes idle capital that just sits there doing nothing.

2. Volume: Volume can be faked by wash trading, showing it far higher than in reality.

3. Revenue or Fees Collected: As suggested in prior literature, Revenue or Fees collected seems to be the most accurate indicator. It is costly to manipulate compared to the other two metrics and is essentially the revenue a DEX generates, derived from TVL and volume.

To succeed, AMMs need to address challenges such as liquidity, impermanent loss, low capital efficiency, transaction speed, slippage, and front running. While TVL and Volume are commonly used as success indicators for DEXs, they have their limitations. Revenue or Fees collected seems to be a more accurate and robust metric as it is costly to manipulate and reflects the actual revenue generated by the DEX.

Key Features DEXs Should Consider

1. Price Oracles: Proper pricing mechanisms are essential, and most DEXs use an oracle for this purpose. Popular options include Chainlink, Pyth, and Stork.

2. Fees: To generate revenue, DEXs need to charge fees for various actions like swapping, LP minting, LP burning, liquidations, market making/taking, withdrawals, or deposits. Standard fees usually range from 0-1%.

3. Bribes: Bribes are used to attract liquidity. There are two common types: voter bribes and gauge bribes. Voter bribes target pools with voter bribes attached, and payouts usually come from the emission pool. Gauge bribes are provided by the underlying LP project to incentivize liquidity and pay rewards in their native token.

4. Rebates: Rebates work as reimbursement to market makers for the provided liquidity on the exchanges. Some DEXs, like dYdX, offer rebates.

5. Trading Incentives: Trading incentives are important in the early stage of the project to bring users, increase traction, and initiate revenue generation. Different incentives are applicable to different pools depending on the strategy, needed liquidity, and risk profile of the LPs.

6. Loyalty Program: Loyalty programs are targeted to attract new users and incentivize them to perform actions that are favorable for TVL/Volume/Revenue or any other KPI.

7. Revenue Redistribution: This became effective and important following GMX's success. It works in a circle: the higher the protocol revenue, the higher the rewards paid out to the participants; the more users trade, the more rewards are there for them.

8. Hooks: Hooks became popular with the introduction by the CoW Protocol and will be a key feature in the upcoming Uniswap V4. They are contracts that run at various points of a pool action's lifecycle and can be executed before and/or after the order.

9. Protocol Owned Liquidity (POL): POL, first introduced by Olympus Pro, allows projects to deploy their own liquidity through a feature called Bonds or Bonding. Bonding means that the protocol sells its tokens to the buyers at a discount, who provide another token in return. This token eventually forms part of the protocol’s treasury.

Important Considerations

• Fee Structure: Apply higher fees to actions you want to minimize in the ecosystem and vice versa.
• Reward Distribution: In the early stages, rewards and incentives will come from emissions as revenue generation is not yet stable. It is important to structure this carefully to incentivize early adopters.
• Sell Pressure: There will be strong sell pressure eventually if you pay rewards in your native token. This can be partially mitigated by vesting or locking the paid-out rewards or by paying out rewards in a non-native token.
• Hooks: Pre-hooks can be used to define conditions or parameters for an order, while post-hooks execute after a swap takes place and enable the funds to be used immediately.

Overall, these features should be carefully considered and aligned with the DEX's strategy to attract liquidity, incentivize users, and generate revenue while managing risks like sell pressure.