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Defi Watch: Will AMM and Liquidity Mining Cool If a Bear Market Comes?

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In a bull market, automated market making will yield LP higher returns than traditional market making strategies. In a bear market, traditional market makers do much better than automated market makers.

Defi Watch: Will AMM and Liquidity Mining Cool If a Bear Market Comes?

Wu said blockchain

In this bull market, AMM and liquidity mining converged to create the Defi wave, and all kinds of innovation proliferated. But we must also see that by its very nature it requires new tokens of liquidity mining to compensate for fickle losses.

At present, the industry has a view forecast, as the spread of vaccines lead to monetary policy adjustment, bear market may come as early as the autumn. So can the AMM and liquid mining that underpin the DeFi frenzy continue?

AMM(automated market maker), the dominant mode of DEX, is popular because it is decentralized and offers "yield farming" (fluid mining). However, the design itself has many drawbacks compared to the order book model used by traditional exchanges.

For market maker strategies in traditional exchanges, an excellent market making strategy needs to meet two requirements: 1. Enough volume can be completed. 2. Avoid inventory risk to the maximum extent, that is, unpredictable losses in AMM.

Current market-making models such as Uniswap and Sushiswap are flawed because Uniswap does not take advantage of the high volatility of crypto assets to earn spreads as traditional market makers do, and requires arbitrage intervention to align its prices with those of a centralized exchange.

This design is more for the convenience of the user to trade, but at the expense of the LPs (circulation providers) profit. Most AMM returns, if earned solely on fees, are scary compared to the fickle losses of a bear market, especially after stripping out liquidity mining rewards.

Just as Uniswap has eliminated the liquidity mining incentive, other automated market makers like Sushiswap cannot compensate LP's fickle losses with liquidity mining forever. The effect of removing liquidity mining may not be apparent in a bull market, where the risk of participating in market making is relatively small. But in a bear market, where income from fees is bound to decline and fickle losses increase exponentially, LPs have many reasons to withdraw liquidity.

(In a bull market, even if LP's currency rose fivefold, it only lost 25% compared to not participating in AMM; But in a bear market, LP's losses increase exponentially.)

For the average defi user like me, there are two questions that need to be answered in order to know the sustainability of doing LP in AMM: 1. If there is no liquidity mining, can we still generate enough revenue? 2. Do traditional market makers have better market-making strategies compared to AMM?

Liquidity mining is by its nature an unsustainable reward that can only compensate LP's fickle losses in the short to medium term. For LP, the only sustainable revenue comes from the fees generated by users using Dex. However, the difficulty for AMM is that if it stops the flow of mining rewards, it can easily lose TVL(Total Locked Value) or be attacked by vampires.

As the head Dex, Uniswap has eliminated the liquidity mining rewards, but it is still profitable to earn fees alone. The APY Vision showed an average fee of 53% over the past 30 days. But that doesn't mean all AMMs are the same. In fact, even Uniswap lost a lot of liquidity in the short term after suspending liquidity mining incentives in November 2010. Not to mention the vampire attack completed by Sushiswap last August. In the case of Sushiswap, the average 30-day return from fees is only around 15%, because of lower volume.

Source: APY Vision

虽然目前对 Uniswap 来说仅靠手续费就可以赚取足够多的收益，但是一旦进入熊市中，手续费降低，随着无常损失指数型增加，AMM 的 LP 没有理由不撤出流动性。

The strategy of a traditional market maker is completely different from the automated market maker logic of Uniswap. For traditional market makers such as Citidel and Jump Trading, their profits come mainly from "buying low and selling high" assets to earn spreads, and traditional market makers do not earn as much or even pay fees to complete trades as automated market makers' LP do.

As a result, they care a lot about managing "inventory risk". For example, when making a market in BTC/USDT, a traditional market maker, like an LP in an automated market maker, would prepare 50% BTC and 50% USDT, but the traditional market maker would confirm the "reasonable price" of the BTC and place orders at this "reasonable price" to buy low and sell high. If BTC suddenly drops sharply, traditional market makers will analyze the reasons for the drop and determine whether it will be lasting. If it is persistent, a traditional market maker will stop buying low and start selling low to balance out its inventory ratio. When the decline is over, traditional market makers will resume "buying low and selling high". Currently in the crypto space, services such as Humming Bot, which provide traditional market making strategies for ordinary users, are far less popular than automated market makers.

The advantages of automated market makers and traditional market makers are a bit like two sides of a coin. On the one hand, while automated market makers cannot "withdraw" liquidity as often as traditional market makers can when the market falls, LPs can earn most of their fees and participate in liquidity mining. On the other hand, traditional market makers can more flexibly judge whether the current market situation is suitable for market making, which greatly reduces the risk.

Simply put, in a bull market, automated market making will yield LP higher returns than traditional market making strategies. In a bear market, traditional market makers do much better than automated market makers.