Once touted as the cornerstone of DeFi, will AMM go down the drain in the future?

AMM reduces the market-making mechanism for cryptocurrency assets to its simplest financial prototype.

Billions of dollars have flowed into decentralized trading protocols based on the Automated Market Maker (AMM) model, a model that creates a self-contained ecosystem of traders and gainers by using project tokens to incentivize liquidity to channel network effects.

The automated market maker model has driven DEX to compete with CEX by having the ability to use cash from their balance sheet to pay for user acquisition (e.g. bonuses through signups and referrals). As a result AMMs have been hailed as the cornerstone of DeFi, spawning multiple forms and sparking the popularity of liquidity mining that has attracted billions of dollars into smart contracts.

But beneath the supposedly solid foundation of the DEX model lies a secret that could bring about its demise.

The Demise of AMM
AMM reduces the market-making mechanism for cryptocurrency assets to its simplest financial prototype. Two liquidity pools are combined with exchange rates that naturally adjust to market demand. Almost like an ancient trader standing between two piles of grain and beans, swapping one for the other on demand.

This inefficient model means that the biggest beneficiaries are not liquidity providers or traders, but arbitrageurs.

Traders need to endure high gas and inefficient execution. amMs are isolated from each other, with little interoperability, and traders deploy capital across different protocols and blockchains in search of deep liquidity.

Liquidity providers passively sell tokens with rising exchange rates and buy tokens with falling exchange rates, generating impermanent losses when digital assets are purchased from sellers and then lose value before being sold to buyers. Thus, unlike active market makers on exchanges, they may suffer losses from fluctuations in market coin prices.

Meanwhile, arbitrageurs enter the pool and buy low-priced assets until the asset pool is correctly priced.

Developers have tried to fix these problems, tweaking parameters and introducing new features such as impermanent loss insurance and a third-party interface to manage trades. But what can be done is limited. Uncommon losses are built in and cannot be completely eliminated, but can only be passed on to other protocol participants who manage risk by sharing profits and losses.

In the end the only way to ensure continued profitability for liquidity providers on AMM is to offset losses through high incentives for newly created tokens.

When the wave of speculation around a new project ends, buyers disappear and then the inevitable selling pressure pulls the price of the coin down, which causes liquidity providers to move to more profitable, new-out projects. Anyone holding a governance token is only likely to vote for the greatest, short-term financial gain, to the detriment of the project.

The rise of middleware
Over time, the AMM model is being threatened by another inherent blockchain limitation: the lack of interoperability.

Yield activity fueled by token incentives outweighs the scalability of the underlying blockchain. This pushes up fees and delays transactions, prompting liquidity providers to turn to AMMs running on new sidechains, layer 2 and next-generation layer 1.

But each new blockchain is a silo. Moving assets across chains, especially between layer 2 networks that are isolated from each other, can mean being forced to go back to the original layer and then jump to the final destination. In the process, the liquidity provider’s revenue is consumed by the underlying blockchain gas fees and has to go through long queues, not to mention, the headache of tracking funds from different locations.

In this multi-chain future, middleware has a great opportunity to be the first stop for liquidity.

Interoperable middleware can interact trustlessly with different chains to find the most efficient route to trade among multiple sources of liquidity, whether from a Uniswap pool or a DEX like Serum that supports centralized order book trading. in this way, we can enjoy the same fun as one layer of trading, but without the latency of trading, the high amount of gas and the isolation from each other that prevents operate across chains. For the end user, the underlying protocol or platform that provides liquidity is simply abstracted through a single user interface, similar to the way cryptographic standards like “HTTPS” are abstracted on the Internet.

User-Centric Token Economy Rules
With no inherent limitations of AMM, Layer 2 middleware is better able to accrue value and create a sustainable crypto economy that rewards all users.

This means going beyond the token incentives that power the first tier blockchain, beyond the “utility” and “security” tokens of 2017, and beyond DeFi’s governance tokens.

The new token economy model not only rewards liquidity providers and validators, but incentivizes all users online to generate real long-term network value. With this, not only will traders flock to the middleware to save on gas fees and increase transaction efficiency, developers will take advantage of the efficiency of the second layer to build DeFi applications, and liquidity providers will come to be most profitably compensated.

Suddenly, the liquidity war between AMMs raging on the underlying chain will be fought on a new battlefield.

The views, ideas and opinions expressed here are those of the author and do not represent those of Cointelegraph.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/once-touted-as-the-cornerstone-of-defi-will-amm-go-down-the-drain-in-the-future/
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