The Risks and Rewards of Trading on Automated Market Makers

5tGG...kNBo

12 Nov 2023

Decentralized finance (DeFi) has exploded in popularity over the past few years. One of the key innovations driving this growth is automated market makers (AMMs). AMMs allow digital assets to be traded directly between users without intermediaries like centralized exchanges. This opens up access and reduces costs for everyday traders. However, the algorithms behind AMMs are complex and their incentives are not always aligned with users.

What are Automated Market Makers?

AMMs are smart contracts on a blockchain that facilitate trading between cryptocurrency assets. They hold reserves of the assets being traded and use algorithms to determine prices based on supply and demand.

The most popular type of AMM is the constant function market maker, which uses a mathematical formula to price assets. The formula uses the ratio between the reserves of the assets to determine the exchange rate between them. As trades occur, the reserves are automatically rebalanced to move the price towards the market rate.

For example, an AMM may hold 10 ETH and 100 DAI stablecoins in its reserves. It would price 1 ETH at 10 DAI. If someone trades 5 ETH for DAI, the reserves would shift to 5 ETH and 150 DAI. The new price would be 1 ETH = 30 DAI. The math behind the formulas is complex, but essentially assets with lower reserves become more valuable.

AMMs have become integral to the DeFi ecosystem. Major protocols like Uniswap, Curve, Balancer all use AMMs in some form. Billions of dollars in crypto assets are traded through them each day.

Benefits of Automated Market Makers

There are several features that make AMMs highly appealing to everyday crypto traders compared to centralized exchanges:

No intermediaries - Assets are traded directly between users' wallets through smart contracts. There are no centralized parties holding funds.
Accessibility - Anyone can become a liquidity provider on AMMs. There are no restrictions and funds can be supplied directly from a wallet.
Low fees - Trading fees are typically 0.3% or lower, much less than centralized exchanges. Fees are paid to liquidity providers.
Transparency - AMM smart contracts are open source and can be audited. Users know exactly how pricing algorithms work.
Censorship resistance - No single entity controls an AMM. Anyone can build interfaces to interact with the underlying smart contracts.
Composability - AMMs are programmable money legos that other DeFi apps can plug into. This enables incredibly flexible financial products.

These features give everyday traders more control, flexibility, and transparency compared to centralized platforms. However, AMMs also come with unique risks traders need to understand.

Liquidity Risks

The biggest risk of trading on AMMs is liquidity risk. Liquidity refers to the amount of funds available in a market maker's reserves. Higher liquidity makes trading smoother by reducing slippage (difference between expected and actual price) and allowing larger orders to be filled.

AMMs rely on external liquidity providers to fund their reserves. These are users who deposit equal values of the tokens being traded into the pool. In exchange they earn trading fees proportional to their share of the pool. For example, you could provide 10 ETH and 10,000 DAI to earn a percentage of the trading fees.

The problem is liquidity is never guaranteed. It can fluctuate widely based on external factors:

No guarantees - Liquidity providers can remove funds at any time if more profitable opportunities arise elsewhere. This shrinks available trading liquidity.
Fragmented liquidity - Too many small AMMs dilute liquidity across platforms. Traders may struggle to execute larger orders without significant slippage.
Changing token values - If one asset changes value significantly, it throws off the reserves ratio. This skews prices until new liquidity restores balance.
Volatile assets - Speculative assets can see huge trading surges, draining liquidity reserves. This causes greater volatility and slippage.
Technical risks - Bugs or hacks of AMM contracts can lead to loss of reserves and liquidity crises.

Everyday traders generally desire predictable pricing and ability to buy/sell instantly. Liquidity risks make this harder on AMMs compared to centralized exchanges with stable liquidity sources.

Impermanent Loss

Another key risk faced by liquidity providers is impermanent loss. This occurs when the trading price of the assets in a pool diverges from the original ratio at which they were deposited.

For example, say you deposited 10 ETH and 10,000 DAI when 1 ETH = 1000 DAI. This gives you 50% of the pool share. A month later, ETH has increased in value to 2000 DAI. Your original ETH is now worth 20,000 DAI if traded at the market rate. However, the pool reserves still only hold 10,000 DAI. You are now exposed to 50% of the DAI in the pool but only 25% of the ETH. Your total holdings are worth less than if you simply held the original assets.

This loss is "impermanent" because if the ratio later rebalances to the original levels, your loss disappears. However, if the prices diverge further, your loss is locked in. Large price swings for volatile assets can lead to substantial impermanent losses.

Liquidity providers need to actively manage their pool positions and withdraw if necessary to avoid growing losses. Failing to account for impermanent loss can greatly reduce total returns.

Manipulation Risks

AMMs rely on simple mathematical formulas to price assets. This makes them vulnerable to manipulation by traders with significant capital. Traders can take advantage of the automatic rebalancing done by AMMs after large trades in order to move prices in their favor.

For example, a trader could:

Drain reserves - Rapidly trade one asset to drain its reserves. This skews the price ratio towards that asset based on limited liquidity.
Frontrun trades - Monitor pools for pending large trades. Front run them by buying/selling the asset first to move the price, then profit from the original trader's order.
Pump and dump - Accumulate one asset then dump it into the AMM to drain reserves and pump up the price. Sell after price jumps.

These manipulation tactics work because AMMs lack robust oracle and pricing mechanisms beyond simple ratios. Without additional sources of "price discovery", prices can be moved arbitrarily through large trades.

Everyday traders typically lack the capital to counter such manipulation. They end up forced to trade at artificially skewed prices which benefit manipulators. This highlights the risks of AMMs' simple formulas.

Governance Challenges

AMMs are "decentralized" in that they are autonomous smart contracts. However, they still rely on some centralized governance processes:

Parameter changes - Fees, asset weighting, formulas can be altered. Who has authority to make these changes?
Oracle management - Getting reliable price data into AMMs is critical but complex. Centralized governance is often still required.
Bug fixes - Contracts may need upgrades to fix vulnerabilities. How can proper fixes be coordinated?
Admin keys - Admin roles with special abilities create central points of failure if keys are compromised.
Listing approvals - Deciding which assets can be traded requires centralized control to avoid illiquid or scam tokens.

While AMM governance is intended to be "community-driven", everyday users have little say compared to core developers and investors. Governance power centralizes among smaller groups over time.

This can be problematic when governance changes directly impact trading prices or availability of assets. Everyday traders may find certain assets blocked or experience pricing skews from parameter changes.

Automated market makers offer significant benefits over centralized exchanges - transparency, accessibility, composability. However, AMMs also come with unique risks everyday traders should understand before relying on them:

Liquidity risk - Volatile or inadequate liquidity makes pricing less reliable for trades.
Impermanent loss - Divergent prices can impose losses on liquidity providers.
Manipulation - Lack of sophistication leaves AMMs vulnerable to manipulation.
Centralized governance - Upgrades, listings, and parameters are controlled by small groups.

These risks are real and need to be factored in by traders. DeFi is still an emerging technology and AMMs have room to grow when it comes to balancing decentralization with effective governance and price discovery. As the space matures, many of these weaknesses may be addressed through innovation.

Ways AMMs Can Earn Traders' Trust

More work is needed for automated market makers to fully deliver on the promise of decentralized trading without intermediaries. Here are some solutions that could help AMMs earn the trust of everyday crypto traders:

Use More Robust Pricing Oracles

Expanding the data sources and using median prices across oracles makes manipulation harder.
Decentralized oracle networks like Chainlink improve reliability over single source oracles.

Adopt Liquidity Mining Programs

Allowing users to earn governance tokens for supplying liquidity creates stable capital pools.
Rewards help offset impermanent loss risks.

Implement DEX Aggregators

Aggregators compile liquidity and pricing across multiple AMMs into a single interface.
This makes slippage less likely for larger trades.

Utilize Automated Strategy Managers

Smart contracts can automatically move liquidity provider funds across pools to maximize yield.
This prevents losses from volatility or shifting incentive programs.

Incorporate More Price Discovery Mechanisms

Limit order books beyond simple AMM reserves can help stabilize pricing.
Integration with centralized exchange data can reduce isolated price manipulation.

Decentralize Governance Through DAOs

Turning governance over to decentralized autonomous organizations representing stakeholders reduces centralization risks.
DAOs allow broader user participation and oversight in governance decisions.

Develop Formal Insurance Programs

Allowing users to purchase protection against smart contract risks like hacks or bugs would provide peace of mind.
Participation incentives for providing insurance capital could be implemented.

Drive Further Interface Standardization

Common interface standards across DEXs and AMMs will increase usability for traders.
Consistent experiences prevent locking users into specific platforms.

Conclusion

The benefits of AMMs in improving transparency, accessibility, and flexibility compared to centralized alternatives are real. They deserve consideration and participation. However, traders should also be aware of the unique liquidity, manipulation, and governance risks discussed. As solutions to these issues are implemented, AMMs have the potential to earn the full trust of everyday traders.

Rather than avoiding AMMs completely, traders should start slowly - assess proven AMMs like Uniswap, provide only limited liquidity to test incentives, use aggregators and limit orders for trades, and monitor governance controls. Over time, experience combined with improving practices and risk management from AMM developers may address many of the concerns raised.

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