Making sense of Defi concepts - AMM

Despite having heard about DeFi earlier, I have yet to explore this thriving crypto jungle. This post serves as a kick-starter.

Introducing one of the popular Defi application out there - AMM, which stands for Automated Market Maker (AMM).

What is an Automated Market Maker (AMM)?

General definition of a market maker by Investopedia:

A market maker is a individual market participant or member firm of an exchange that also buys and sells securities for its own account, at prices it displays in its exchange's trading system, with the primary goal of profiting on the bid-ask spread, which is the amount by which the ask price exceeds the bid price a market asset. It is typically a bank or financial institution.

In the DeFi space they have it automated, letting the community profit instead. Hoo ha!

"Not only can you trade trustlessly using an AMM, but you can also become the house by providing liquidity to a liquidity pool. This allows essentially anyone to become a market maker on an exchange and earn fees for providing liquidity."

Earning fees (yield farming) for providing liquidity sounds like cool stuff ya?

So let's try figure what's in it.

Read this or view the video near the bottom of this post.

Liquidity Pool explained

Liquidity pool is the "market place" where you have 2 or more of the assets in pools for traders to trade / swap. 

As a liquidity pool (LP) provider, you would supply the stipulated assets thus providing "liquidity" (as mentioned above) according to the rules of the smart contract in the protocol.

"Be wary of projects where the developers have permission to change the rules governing the pool. Sometimes, developers can have an admin key or some other privileged access within the smart contract code. This can enable them to potentially do something malicious, like taking control of the funds in the pool. Read our DeFi scams article to try and avoid rug pulls and exit scams as best you can."

On top of that, there is this concept of impermanent loss that could happen when you do LP. No free lunch in this world, duh!

So what on earth is Impermanent Loss

Ok here you go, click and read to unfluff the scramble eggs in your mind.

Impermanent loss curve

"Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them." (meaning you can make a loss when you withdraw your crypto from the pool.)

"As a simple rule, the more volatile the assets are in the pool, the more likely it is that you can be exposed to impermanent loss." 

If you don't want to crack your brain with calculations, here's an Impermanent Loss Calculator online to the rescue.

The Alice example in the article points to the fact that you could earn quick bucks as an arbitrage trader in a liquidity pool that has much liquidity yet not many sharks around (arbitrage traders that fight with you before the ratio balances to the market rate). On the other hand, a liquidity provider welcomes more traders (or high trading volume) as that would mean more trading fees earned for them.

What's arbitrage? When there's a spike in market price say for ETH, they can withdraw ETH from the pool to sell (outside) for spread profit and thus upset the pool's ratio. Since what determines the price of the assets in the pool is the ratio between them in the pool.

However, since your % of the pool owned remains unchanged, the change in pool ratio would then realize an impermanent loss when you withdraw from the pool. Theoretically speaking, the bigger the pool size, the lower is the risk of impermanent loss.

Do remember, where there's blood sharks will come...

"One last point is to look for more tried and tested AMMs. DeFi makes it quite easy for anyone to fork an existing AMM and add some small changes. This, however, may expose you to bugs, potentially leaving your funds stuck in the AMM forever. If a liquidity pool promises unusually high returns, there is probably a tradeoff somewhere, and the associated risks are likely also higher."

Here's a writeup about Uniswap (one of the very popular AMM)

Closing thoughts

Unless I am more capable of navigating these rules and their limitations, I will likely to remain on the sideline instead of jumping headlong into a pool that may be too deep for my "swimming skills". 

Maybe I can attempt to be a shark, but I certainly don't want to end up as the shark's fin on others' dish. (Everyone wants a bite of everyone's crypto... just like everyone wants a bite of everyone else's share of money when trading in the stock market.) 

Some bloggers who are making big and quick bucks may exhibit confirmation bias in their articles, thus, I would advise anyone who are interested in crypto venture to always exercise your own due diligence.

Lastly, don't get rekt!

Liquidity explained:

Do you know that what you can do in the Tradfi (traditional finance) world can be done in the Defi world as well? All through smart contract interactions.
  • Borrowing / Lending
  • Insurance
  • DCA (on platforms)
  • Value investing
  • "Dividend" investing (yield farming, staking)
  • Momentum trading
And there may be so much more...

What is Defi?

"DeFi refers to a system where software written on blockchains makes it possible for buyers and sellers and lenders and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction." - Investopedia

I can foresee DeFi's disruption to traditional bank services if it can provide stable infrastructures and ease of use for businesses and the masses to carry out financial transactions (lending, borrowing, trading, payment etc). If it has not already happened in some parts of the world. 

A side point to note is that banks are also jumping on the bandwagon of cryptocurrency. Hmm are we going to be seeing more crypto-derivative products in the near future? 

Bitcoins IOUs? Erm no thanks, it's like how I would rather hold gold than the gold derivatives.

Some risks to consider with Defi

"The DeFi ecosystem is still riddled with infrastructural mishaps and hacks. Scams also abound in the rapidly-evolving DeFi infrastructure. DeFi “rug pulls,” in which hackers drain a protocol of funds and investors are unable to trade, are common, though there are well-established protocols that can be used to reduce this risk significantly." 
- Investopedia

"There are an incredible number of risk factors piled up on top of each other in the world of DeFi apps. These apps are crudely glued together based on potentially-faulty smart contract code, trusted oracles, developer-controlled backdoors, volatile underlying network tokens (e.g. ETH, BNB), centralized stablecoins with plenty of counterparty risk, yields denominated in Ponzi-esque crypto tokens with unclear utility, and other problematic building blocks."
How bitcoin and defi are completely different phenomena

Resources for newbies

To familiarize with the crypto terms...

I have been using Blockfi to earn some interest on my cryptos, which are of much higher rates than banks'. To visit my updated grumbles on DBS fixed deposit and their terms click here.

Undeniably, I have to undertake a bigger risk (mainly custodian risk) by not depositing in the SG banks or any MAS approved institutions. I take that as a trade-off for better yields.

GUSD interest rate on Blockfi is currently 8.6%. It's Cefi not Defi, in case you wonder. You can sign up with my referral if you are interested.

Blockfi's cash withdrawal is subjected to minimum of GUSD5000 per withdrawal. No minimum for GUSD withdrawal as crypto to other platforms. Subjected to only 1 free withdrawal per month.

Alternatively, you can transfer GUSD to Gemini and swap them to USD for trading or withdrawal.

Defi concepts to be continued...

Related posts: 

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Check out my referrals for fantastic sign up bonuses on SAXO, Moomoo, Gemini, Celsius, Blockfi and more.

Thanks for reading!


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The contents of this blog are author's personal opinions and do not constitute advice to hold, buy or sell any securities, commodities or assets mentioned. I do not guarantee the accuracy and reliability of any information provided, and shall not be liable for any losses incurred from reading my posts or using the materials herein. This blog may contain affiliate links to external sites.