Author | Ling Young Loon
Why is market maker important?
The financial sector is always better than market makers means that the equation x * y = k of the more. In the traditional Central Limit Order Book (CLOB) market, the market maker is responsible for submitting the buying and selling of the order book. When you make a market purchase on FTX, your counterparty may not be another targeted trader, but a market maker company! Most high-frequency trading companies, even banks, allocate part of their portfolio to Market maker activities. Well-known companies include Two Sigma, Citadel and Jump Trading.
Market makers are particularly important in traditional markets, because directional traders alone cannot provide sufficient liquidity for market operations. This is caused by several reasons:
- The dispersion of information . Buyers cannot communicate effectively with sellers, especially when trading long-tail assets.
- Some market participants require transactions to be executed immediately . But in reality, transactions take time to settle.
- Liquidity is asymmetrically affected by market sentiment . It increased in a bull market, but dried up in a bear market. You can see this in the dollar value of the open interest of Deribit options.
- Large transactions (huge buying and selling) are affected by high prices .
These problems affect price discovery, increase market volatility, and generally make the market more inefficient. In DeFi, the lack of market makers that provide liquidity can explain why the newly launched Token has seen huge price rises and falls. As we said before, this is why you should set up smart alarms for the transfer of tokens exceeding the value of USD based on the depth of the Token’s liquidity pool.
Why do people make markets?
DeFi market makers profit from transaction fees and receive certain liquidity rewards. This is not much different from traditional market makers, which profit from the bid-ask spread. That is, the difference between the buy and sell orders they set.
Income comes with risks. DeFi users are afraid of impermanent losses, while institutional market makers try to reduce the risk of asset prices changing over time. Market makers are traditionally a complex business; institutions compete in various ways. They constantly adjust their spreads and transaction amounts, buy hedging instruments from the derivatives market, and execute lightspeed orders on low-latency software.
Because of this, it is difficult for an independent trader to make a market in the CLOB market. Although there are some programs that can help you do this, institutions have scale advantages in almost all aspects of market making.
Enter automatic market making
Automatic market makers (AMMs) introduced the concept of “lazy market making”, completely subverting this model. The assets in DeFi will be deposited into a contract called “liquidity pool”, and then various traders can trade against the pool. It is called “automation” because the asset price in AMM changes according to a predetermined mathematical formula. One of the formulas is Uniswap’s constant product formula x * y = k, where x and y are the reserves of two tokens. The balance of the two reserves must be multiplied at all times to form a constant k.
Over the years, other AMM formulas have also been known to everyone, and each formula has its own pricing curve . There is a feature that runs through all these formulas. Market making is automated, and it may be simple.
Enter Uniswap V3
Uniswap V3 has brought obvious changes to the AMM model. It increases the flowability customizable positions, allowing the user to set a predetermined price range of assets . You can think of a single V3 liquidity position as an AMM with x*y=k, only working within the set price range. Quoting Dan Robinson’s work, the relationship between assets pooled in a single V3 position can also be expressed by a formula:
The “offset” here is a function of setting the lower and upper limits of the price range. As I mentioned in the previous article, this greatly enhances the capital efficiency of centralized assets. It gives users the ability to customize an overall market-making position by having different liquidity positions at the same time.
However, capital efficiency comes at a price. You face the risk of market prices falling outside the market maker range you set. For example: you concentrate the liquidity of the ETH/USDC pool in the price range of 1000-2500 USD. When the price of ETH drops below $1,000, you will end up holding only ETH. When the price of ETH exceeds $2500, you end up holding only USDC. In both cases, you will stop the cost of earning assets and be exposed to the decline in the single asset you hold .
This is the difficulty of making a market on Uniswap V3. The provision of liquidity is no longer simple and passive, but requires monitoring and strategic adjustments. In this article, we analyzed on-chain data to find empirical insights on Uniswap V3’s market-making behavior.
Each Uniswap V3 position has a unique NFT Token. We analyzed data on 5 different events related to liquid position management.
- NonfungiblePositionManager.sol issued to increase liquidity, decrease liquidity and transfer events.
- Mint & Burn incident issued by UniswapV3Pool.sol
By piecing together the data of these events, we can find the update frequency of a particular liquid position (ie, NFT). Using transfer events, we can find the ultimate owners of these current NFT positions. If the last owner is the burned address, we take the last second owner as any “owner” of the NFT position.
Assume that the NFT transferred from one Ethereum address to another Ethereum address ultimately belongs to the same owner. There is no open market for buying and selling Uniswap V3 NFT positions. There is also no reason for people to buy NFTs instead of buying basic assets and providing liquidity by themselves.
If Uniswap V3 liquidity providers (LPs) actively manage liquidity, one would expect V3 LPs to frequently change their liquidity positions. This may be done in a freely determined manner, through some off-chain algorithms, or through on-chain contracts. We did a short exploratory analysis to analyze how Uniswap V3 is used by LPs.
Among all current V3 position holders, 58% of addresses have only one liquid position . In fact, less than 10% of addresses that provide liquidity on V3 have more than 5 NFT positions.
Using these data, we can calculate an arbitrary activity score by summarizing the number of “increased liquidity” and “decreased liquidity” events attributed to the address. This includes NFTs burned by that address. We draw a scatter plot of the number of positions held and the activity score for each address.
Trends indicate that the activity scores of addresses consistently exceed the number of positions they have. Few addresses have more than 150 NFTs. We can also infer that the increase in activity is disproportionate to the number of positions held.
Let’s add a bit of color to this data using the classification heuristic shown below.
A “simple passive” address is an address that only has a Uniswap V3 position, and no changes have been made since then. In every sense, it is a lazy liquidity provider. Then “complex active” refers to liquidity providers that have multiple positions and actively manage them. This can be inferred if its activity score is higher than the number of tokens it has. We choose 2 as an arbitrary threshold to meet the active conditions.
In total, we found that 22864 unique addresses have/have positions on Uniswap V3. A large portion (77%) of these LPs are still considered passive liquidity providers. This means that they have almost never changed their liquidity positions after minting. 14% of owners are classified as “simple initiative”, while less than 1% of owners are “complex initiative”.
There are exactly 8 ” complex passive ” liquidity providers. I expect most of them to be Stake pools, such as Raini’s LP V3 Stake pool, but 6 of the 8 addresses are actually wallet addresses (ie not contracts).
Historical patterns of liquidity supply
Let us now observe the liquidity supply pattern from May to June 28. This can be done by tracking the historical miners and burnings of each day.
- The sudden emergence of high liquidity “spikes” at certain prices seems to cause changes in the ETH price the next day.
- Since mid-June, the overall depth of liquidity has generally declined.
How well does the liquidity of the ETH/USDC pool track the price of Ethereum? We plotted the 25th, 50th, and 75th percentage points of the daily liquidity amount and compared them with the ETH/USD price. Liquidity is usually concentrated in this range.
In May, the liquidity distribution on V3 has closely tracked the changes in the price of ETH. This makes sense, because market makers can adjust their positions within the range to earn more fees . However, since mid-June, the liquidity on V3 has not kept up with the fall in the price of Ethereum. As the price of ETH fell below $2,000, the reaction of LPs on Uniswap was to expand the range of market makers, as can be seen from the widening of the gap between the 25th and 75th percentile liquidity. Will this trend continue? Only time and data can explain the problem.
The pattern of active liquidity management is still in its infancy in DeFi. Visor Finance currently runs a strategy to derive the Bollinger Bands from the ETH/USD price to create a predicted active liquidity range. On the other hand, Charm Finance operates a passive rebalancing strategy to ensure that the concentrated liquidity range “catch up” with market prices.
As the data shows, the potential of Uniswap V3 is still untapped. Passive and simple liquidity positions still dominate, and most positions are managed randomly and non-optimally. This gap is a shining opportunity for the new agreement to establish an automated on-chain strategy to help proactively manage liquid assets, which will democratize the opportunity for daily DeFi users to obtain market making. These agreements are critical to the success of Uniswap itself.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/what-is-the-progress-of-uniswap-v3s-active-market-making-program/
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