Market making is an inevitable part of the DeFi ecosystem. Both, private and automated market makers play a vital role by providing liquidity. As of June 2023, the ‘Total Value Locked’ In DeFi protocols was over $100 billion, a sizable portion of which is driven by market makers.
While automated market makers hold significant importance in the space, private market makers are effective as they react to price changes in the market quickly. This article dives deep into the recent developments of market making and how it contributes to the cryptocurrency trading system.
Demystifying Market Making in DeFi
At its core, market-making involves generating liquidity in the markets by adding assets to different crypto instruments. This makes trading on protocols work seamlessly for users. Automated DeFi protocols are devised to ensure transparency across users and the protocol itself. In the absence of private market makers, automated market makers use programmed algorithms to keep illiquidity and market manipulation at bay.
The DeFi market-making process hinges on three key components: AMMs, liquidity pools, and smart contracts. Liquidity pools are communal pots of digital assets pooled from individual liquidity providers, creating a shared marketplace for traders.
While automated market makers aid in ensuring the market does not shut down due to the absence of private market makers, it is safe to say that automated market makers cannot run the liquidity provision service in the best possible way.
The next section will throw light on the nuances of private market makers and automated market makers.
Private Market Making Vs. DeFi Market Making
The private market making landscape involves intermediaries who quote buy and sell prices in financial markets, capitalizing on the bid-ask spread. They are instrumental in ensuring market fluidity, minimizing transaction costs, and alleviating price volatility. To deliver stability in crypto pools traditional market makers use real-time data to ensure that users are not impacted by impermanent loss due to volatile market conditions.
Some of the key advantages that private market makers have are as follows:
They have the capability to hedge their positions in a sophisticated way. Private market makers can adjust their strategies based on market conditions, and PMMs can choose their counterparties depending on the degree of risk involved. Private market makers employ best practices of avoiding high-risk trading
Some of the key advantages that automated market makers have are as follows:
- AMMs are built on decentralized platforms, allowing anyone to participate without the need for permissions or approvals. Which means no KYC is involved in most cases.
- Some AMMs have direct token-to-token swaps which means one can simply swap their cryptocurrency on the platform.
- Automated market makers are interoperable with other decentralized networks. It is easy for anyone to integrate other protocols to seize financing opportunities like opting for a flash loan.
Appeal of Market Making: Why PMMs score better than AMMs?
In terms of accessibility, DeFi is unmatched. Its transparency feature allows anyone with internet access and digital assets to join a liquidity pool, contribute to the protocol, and earn rewards. This open-door policy embraces the core ethos of blockchain technology: decentralization and community participation.
PMMs can offer large amounts of liquidity across different trading pairs. Private market makers, with their significant capital, sophisticated algorithms, and market experience, often provide more efficient price discovery, especially for newly listed or less liquid tokens. AMMs also provide liquidity, however, it is often dispersed and dependent on individual liquidity providers who may not be able to provide much liquidity for less popular assets.
Private market makers can better manage the risks associated with providing liquidity, particularly for highly volatile assets, due to their financial capacity, ability to hedge, and access to various trading strategies. In contrast, individual liquidity providers on AMMs are subject to impermanent loss, which may not always be manageable for less affluent individuals.
Private market makers can handle large orders without significantly impacting the market price, which is essential for institutional participants. In contrast, large orders can cause significant slippage in AMMs, leading to less favorable prices for the trader.
Common DeFi Market-Making Strategies
1. Constant Sum: This technique is implemented to maintain stable liquidity across the pool. The platform incentivizes traders to rebalance the pool by adjusting token prices when the pool becomes imbalanced.
2. Constant Product: This strategy allows users to create liquidity pools with two tokens, and the product of their balances remains constant. When trades occur, the token balances adjust to maintain a new price ratio.
3. Stableswap: Stableswap is a strategy designed for stablecoin trading pairs in DeFi. It aims to maintain a stable price and low slippage and maintain liquidity for stablecoin trades.
4. Dynamic Market Making: Dynamic market making involves timely adjusting of the liquidity provided in coherence to market conditions. Intelligent algorithms fetch and analyze market data to determine optimal pricing and position management.
In automated market makers, the formula used to trade is x*y=k, where x and y are the quantities of the two tokens in the liquidity pool, and k is a constant. In ‘dynamic market making’ ‘k’ becomes the variable. Balancer takes a slightly different approach with respect to the trade formula.
Balancer uses: Π (balance_i ^ weight_i) = k. balance_i represents the balance of a particular token in the pool, and weight_i represents the weight of that token. The product of the balances each raised to the power of their respective weight is always equal to a constant, k.
Automated Market Makers: Win-Win for Stakeholders
DeFi market-making offers a panoply of benefits to a broad spectrum of stakeholders. Participants on platforms like Uniswap are enticed by improved liquidity and concentrated liquidity. Besides high liquidity, participants can also place range orders. Users can place orders to buy or sell tokens at a specific price or within a specific price range. This can be useful for traders who want to take advantage of price movements or who want to limit their risk.
Additionally, DeFi protocols enjoy a surge in liquidity, increasing their overall usability and market appeal. For example, Uniswap, a prominent DeFi protocol, has seen liquidity levels surging to over $5 billion thanks to its AMM model that minimizes slippage and boosts trading efficiency.
DeFi’s Infancy: Pitfalls & Challenges
DeFi also has risks like smart contract vulnerabilities that can lead to potential exploits and substantial asset losses. For example, the Mango market hack.
TLDR; In the mango market hack, the scammer used price manipulation using MNG – a native token of the platform. Before initiating an extremely large long position, the attacker made a network deposit of 5 million USD Coin (USDC). He purchased 438 million Mango tokens, swiftly accruing an unrealized profit of $420 million. The value of the hacker’s account’s collateral increased as the price of MNG rose by about 1,000%. When he obtained more than $116 million in liquidity from all accessible tokens, he eventually destroyed the system.
Furthermore, the DeFi market’s inherent volatility can impact the value of the liquidity providers’ assets, leading to potential impermanent losses.
Conclusion
In the last year, decentralized finance has sparked the interest of crypto traders owing to its transparent and democratic approach. DeFi is a promising space as compared to centralized financial systems.
Crypto degens have been exploring the vast landscape of market making. Compared to traditional financial instruments, liquidity provision via automated market makers offers lucrative returns, but they come with risks. The risk-reward ratio in liquidity provision is higher than in mainstream crypto investing and trading.
It’s worth noting that private market makers and AMMs can coexist in the market and each has a unique role to play. AMMs have played a crucial role in democratizing market making and enabling peer-to-peer trades in the DeFi space, and private market makers are essential for ensuring efficiency, stability, and adequate liquidity, especially for larger, more institutional market participants.
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