Performance of an AMM
It is widely understood today that Automated Market Makers (AMMs) facilitate trading between different digital assets by maintaining reserves of both assets, which, through rebalancing, establish the trading price between them. It can be stated that, based on the size of their reserves, prices are kept more or less aligned with the market price on an exchange, as the invariant (I = Asset A X Asset B) provides a fairer price in the face of large movements. Anyone can become a liquidity provider (LP), so-called because they provide assets in both reserves simultaneously, assuming part of the trading risk in exchange for a share of the returns.
Providing liquidity in a pool with one stable asset and one volatile asset involves dealing with the problem of taking a long position on that volatile asset and the uncertainty surrounding how its price will perform during the time you are a liquidity provider. In a high percentage of cases, money is usually lost by ignoring two important and logical points:
- Not having a well-defined and polished strategy based on planning and methodology that aligns with what you seek in that pool.
- Traders, regardless of the market or environment (centralized or decentralized), always demand and seek a lower buying price than the selling price, and this does not benefit you in any way.
Not to mention or factor into the deadly equation the arbitrageurs or bots, actors that influence the pool and consequently the prices of the assets within it by entering before the purchase or sale of an asset, initially harming the trader and subsequently you as a market maker since it may have caused significant impermanent loss in that pool and resulted in losses for you. For this reason, if the volatility of an asset is high enough in relation to its average rate of return, it performs better within a liquidity pool (i.e., as part of the asset pair for providing liquidity) than with a buy-and-hold strategy. This phenomenon occurs under certain conditions, and it is possible to outperform any static portfolio of two assets because it is periodically rebalanced, providing a fixed 50/50 allocation to each asset.
Returning to arbitrage, while it distorts prices in the short term and hinders your profitability goals, it also acts as an intelligent rebalancer in concentrated liquidity pools. The more frequently it is used, the more implied volatility it adds to the pool, forcing liquidity providers to better determine the price range where they should place liquidity, as these ranges become highly profitable due to the number of swaps and fees generated. Although it may seem like an ideal working environment for an LP, to be honest, the best long-term results are always achieved in a more or less controlled environment within the limits allowed by volatility.
How should the performance of an AMM be evaluated?
As an LP, I ask you to understand that profit generation works similarly to many investments you are familiar with in the traditional sector. For example, companies generate returns because their stocks rise in the market due to various factors (financial statements, demand, stock splits, earnings reports, etc.). In the context of an AMM, this means that market makers, by depositing their assets in the AMM, expect to recover more than their initial deposit. This is known as capital efficiency, which represents the financial performance of an AMM when it allows you to be a part of and benefit from the business.
The factors that need to be analyzed and well-defined are:
TVL = Total Value Locked (provided liquidity)
GMV = Gross Merchandise Volume (generated trading volume)
Revenue = Total trading fees paid
Based on these factors, the following calculations can be made:
- Trading volume per dollar deposited (Daily GMV / Average daily TVL)
- Gross rate of return generated per dollar deposited (Daily Revenue / Average daily TVL) * 365.
In conclusion, the concentrated liquidity of an AMM creates an automatic system that makes your money 100 times smarter or, in other words, 100 times less efficient compared to traditional finance. By connecting your money to a liquidity universe in a system that operates through rebalancing without human intervention, 24/7, 365 days a year, it becomes inevitable for this system to prevail over isolated and archaic systems where you are not part of the business. This goes against the spirit of the new internet era that seeks to connect worlds, systems, people, assets, and money without censorship. Currently, I see no competition in terms of costs, flexibility, immediacy, accessibility, and opportunity. Therefore, something must change, and it’s not cryptocurrencies 😉