A substantial problem with on-chain AMMs
The emphasis of “Decentralized Finance (DeFi)” is undeniable. Blockchain and decentralization have created a whole new financial era where the power is handed back to the people. Banks and financial institutions that act as middlemen and intermediaries create isolated and closed systems that are opaque. Their users have no idea what is going on at the backend, essentially robbing them of their hard-earned profits at the time of crisis.
Today, when we look at the DeFi market, it has grown from a mere $2.6 billion market to over $11 billion in three months. People have faith in technology. DeFi Pulse is the leading DeFi statistics website, tracking all the statistics from the past two years. When DeFi Pulse started publishing the total value locked statistics, it was merely $276 million. Today, the total value locked (USD) in DeFi stands at $11.3 billion. That’s 4000% growth in just two years.
DEXs and AMMs
Decentralized Exchanges (DEXs) are crypto trading platforms that forgo the traditional way exchanges work. One of the significant changes they impart is that there are no order books involved. Instead of books that list buyers and seller orders and matching them, the DEXs use a liquidity pool. That is innovative as putting and removing an order from the order book is an expensive operation for blockchains. Thus, there is no need for external market makers to remove the orders to reduce trade spread. That’s why they are called “Automated Market Maker.”
The liquidity pool based decentralized exchanges allow traders to swap their assets instantly. For example, a person who holds Zilliqa (ZIL) has value but essentially is not utilizing it. They can deposit their ZIL tokens in a DEX liquidity pool that supports the token. For their efforts, the DEX provides earnings by giving them a portion of the trading fee earned.
Problems with AMMs
Although the AMM model of DEXs sounds promising, it is not without its inefficiencies. The biggest one being the price slippage after each trade, which is captured by arbitrageurs as a profit-making opportunity.
For any decentralized exchange, the most prominent supporters are Liquidity Providers, as they put an initial deposit as liquidity so traders can get better prices and a smooth trading experience. They also bear the risk of impermanent loss. At the same time, arbitrageurs make a profit from these arbitrage opportunities without any initial investment. Moreover, they can leverage flash loans to increase their profit by many folds. Due to these reasons, Vertex DEX is committed to providing more profit to liquidity providers.
In the next post, we will see how Vertex will solve these inefficiencies with its innovative AMM solution and provide more profits to liquidity providers.
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