Why are AMMs popular?
Choice of tokens – There is a huge and growing number of cryptocurrencies but only a tiny proportion are supported by centralised exchanges. AMMs fill the gap in the market as there are no restrictions on what coins can be listed so long as liquidity can be incentivised.
No KYC – The DEX model requires no KYC because it doesn’t touch the traditional banking system, and only offers trading in crypto pairs.
Non-Custodial – Decentralised exchanges do not take custody of funds which is why they are described as Peer-to-Peer. A user connects directly with a Smart Contract through their non-custodial wallet e.g MetaMask granting access privileges for as long as they want to interact with the Contract.
What are the risks and limitations of AMMs?
Capital Inefficiency
One of the specific problems of the AMM approach to decentralised exchanges is that for very liquid pools much of the funds are sat there doing nothing. This is because the majority of the time price moves in a relatively narrow range, and the pool will quickly rebalance.
It would take a significant price shift to absorb the majority of liquidity so the majority of capital within the AMM model is deployed inefficiently, essentially doing nothing. Despite this everyone still earns fees in proportion to what they contribute to the overall pool.
Smart Contract Vulnerability
The automated nature of AMMs – functioning via Smart Contracts – is both their key strength and a potential source of weakness. Smart Contracts are deterministic; if conditions are met they execute in full or not at all, but because they are written by humans those conditions – expressed as computer code – can contain explicit mistakes or miscalculations of logic that hackers will look to exploit and abuse.
If a DEX is exploited you could lose your funds with no guarantees that you will get anything back. Chainalysis reported that DEFI accounted for $2.3bn of crypto-related crime in 2021.
Impermanent Loss
Impermanent Loss is the unrealised loss in the value of funds added to a liquidity pool due to the impact of price change on your share of the pool. It’s a factor of the automated nature of DEFI and the volatility of the price of asset pairs.
It’s impermanent because it is only realised when withdrawing funds. Users can claim the proportion of assets added to a lending pool rather than the equivalent amount of value they added to the pool. Impermanent loss can positively and negatively impact liquidity providers depending on market conditions.
Complexity
Though impermanent loss might sound confusing, it is just the tip of the iceberg regarding the complexity and risk of DEFI. Flash loans are the clearest example of how deep the DEFI rabbit hole can go.
A flash loan is a way to borrow crypto funds from a lending pool without collateral, provided the liquidity is returned within the space of one block confirmation.
If the funds are not returned within one block, all the associated actions are reversed as if they never happened.
However, if funds are returned within the space of one block, the lending pool the funds were borrowed from doesn’t lose out because the funds are returned. The person who took out the Flash Loan then gets to keep whatever value they were able to generate across a complex series of transactions, net of the transaction costs associated with each step in the chain.
Flash Loans use custom-written Smart Contracts to exploit arbitrage within the DEFI ecosystem – market inefficiencies across tokens and lending pools. Arbitrage is a natural part of how financial markets mature. Still, Flash Loans are also being used to manipulate and distort crypto asset prices and generate massive returns for those with the skills to understand the dark side of DEFI.
Chainalysis reported that $364million was stolen via Flash Loan attacks on DEFI protocols in 2021.
- See this separate article outlining the risks posed by DEFI
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