Protocol-Owned Automated Market Makers
During the DeFi Summer in 2020, long before SocialFi was a thing, I contemplated bonding curves for a personal token project and was fascinated by the simple idea of a mathematical model that delineates the relationship between token supply and price. This concept revolutionizes token trade through smart contract implementation on blockchains by dynamically defining and adjusting exchange rates. This functionality is not just theoretical; it has been implemented in various forms across DeFi, enabling seamless trade of assets and supporting the fluid economics of small and large token ecosystems alike.
While working as an advisor to Web3 projects in the past, I noticed inefficiencies in token designs predominantly stemming from nonoptimal token issuance mechanisms, fragmented liquidity, and uncaptured trading fees. These shortcomings have long hindered the potential growth and stability of token economies.
This article explores Protocol-Owned Automated Market Makers (poAMMs) powered by comprehensive bonding curve primitives (aka Primary AMMs) that help a Web3 project own its token’s full lifecycle completely and, hence, improving the token design space with an additional value accrual tool driven by a price-supply discovery mechanism that adapts to protocol KPIs, market conditions, and governance decisions.
The Genesis of poAMMs
At its essence, a poAMM leverages the principles of bonding curves to facilitate the primary issuance and trading of tokens within a protocol’s own ecosystem. This mechanism streamlines the token’s lifecycle management and ensures that the protocol directly benefits from every aspect of its economy.
By owning the liquidity and the market-making process, a protocol can significantly reduce its dependency on external liquidity providers (LPs) and market makers, which traditionally have extracted significant value from token ecosystems without necessarily aligning with the long-term interests of the protocol and its community.
It is also crucial to emphasize that poAMMs are not just about price discovery but significantly about supply discovery. This distinction distinguishes them from traditional AMMs, which primarily focus on price discovery.
In the volatile crypto market, the price of tokens is highly sensitive to changes in available supply, such as the impact of a large airdrop or investor unlock. Traditional AMMs and manual supply management by projects often fail to adequately address these dynamics, leading to market inefficiencies.
Key Features of poAMMs
poAMMs introduce a mechanism for the primary issuance and redemption of tokens. They act as a dynamic supply discovery tool, adjusting the token supply based on market demand. When optimized for becoming the primary trading venue using discrete bonding curves, they reach similar capital efficiency levels on well-known DEXs like Trader Joe and Maverick Protocol without requiring external LPs as the poAMM is the primary token issuer and the sole LP at the same time.
This innovative approach addresses the longstanding challenge of pre-determining a token’s lifetime supply, offering a more flexible and responsive model that aligns with the actual needs of the ecosystem while creating a significant revenue stream in terms of trading fees.
The features of poAMMs include:
- Dynamic Price and Supply Discovery: Unlike traditional AMMs, poAMMs introduce a more refined approach by allowing for dynamic supply adjustments in response to market demand. This system goes beyond the mere appearance of dynamic issuance with a truly responsive mechanism that adapts to the ecosystem’s needs. This feature is particularly important for managing the token’s supply effectively, differentiating poAMMs from traditional AMMs by focusing on the underlying supply dynamics that drive price changes.
- Protocol KPIs and Market Conditions Adaptation: poAMMs can be designed to adjust their parameters based on specific Key Performance Indicators (KPIs), market conditions, and governance decisions. This adaptive mechanism allows protocols to tailor their market-making strategies to support their growth, stability, and community objectives, ensuring a more sustainable and resilient economy. In down-trending market conditions, poAMMs offer a strategic tool for managing predictable and manageable declines in price and supply. This is invaluable for protocols exploring degrowth business models or seeking to protect their tokens against extreme price volatility. Through adaptable bonding curve parameters, poAMMs can provide a “parachute” for tokens, cushioning against sudden market shocks and offering a more stable economic environment.
- Full Lifecycle and Revenue Ownership: By integrating the issuance, trading, and liquidity provision processes, poAMMs allow protocols to retain complete control over their tokens’ lifecycle. This comprehensive ownership model enables protocols to capture all trading fees, reinvest these earnings back into the ecosystem, and potentially generate passive yield through DeFi strategies, further enhancing the protocol’s treasury and financial autonomy.
- Governance and Community Engagement: poAMMs naturally embed governance into the market-making process, allowing token holders and community members to participate in key decisions regarding the adjustment of bonding curve parameters, reinvestment strategies, and other economic policies. This engagement fosters a stronger sense of ownership and alignment among the community, driving collective efforts toward the protocol’s success.
- True Market Capitalization: A fundamental aspect of poAMMs that deserves emphasis is how the area under the bonding curve represents the reserve asset volume. This volume is not merely a static figure but a dynamic measure of the project’s true market capitalization. Unlike traditional market cap calculations, which can be heavily influenced by circulating supply and current market price, the reserve asset volume under a poAMM’s bonding curve offers a more stable and accurate reflection of a project’s value. This is because it is tied to actual assets held in reserve, providing a more reliable indicator of financial health and stability.
Revenue Generation
A protocol that employs a poAMM generates revenue from token minting and redemption. If its design is optimized and adapted for general trading, it can also steal a significant trading volume from the CEXs and DEXs it is listed on, boosting its internal economy.
For example, a project with a $100M daily token trading volume leveraging a poAMM would capture up to $3.6M (assuming a 0.1% trading fee) in annual revenue. That would be a significant value captured and reused in the project ecosystem.
Strategic Reserve Management for Income and Stability
The reserves held by a poAMM can be strategically managed to generate passive income and enhance the protocol’s financial autonomy. Here are some innovative approaches:
- Liquidity Staking Tokens (LSTs) Utilization: By accepting assets like AVAX, ETH, and converting these base assets into their Liquidity Staking Token (LST) versions (e.g., sAVAX, stETH), a poAMM can engage in passive income strategies. Keeping these LSTs within the poAMM allows the protocol to earn staking rewards, thereby enhancing its reserve without compromising on liquidity.
- Lending Out Reserves: A poAMM can lend a safe portion of its reserves on lending platforms to earn interest. This strategy must be carefully managed to balance the potential returns against the liquidity needs of the poAMM. To mitigate risks, the protocol can use captured trading fees to buy back and burn its own tokens, effectively raising the floor price of the protocol token. The tokens burned are permanently removed from circulation, ensuring they cannot be claimed from the poAMM, thereby reducing supply and potentially increasing the token’s value.
Future Outlook
The versatility of poAMMs opens up several avenues for future research and development:
- Real-World Assets (RWAs): Expanding the poAMM ecosystem with RWAs could broaden asset scope, diversifying investment opportunities and risk management.
- Dual-Token Bonding Curves: In gaming or other specialized applications, dual-token bonding curves could provide a nuanced mechanism for managing in-game economies, rewards, and incentives, enhancing the gaming experience and economic sustainability.
- Multi-Asset poAMMs: The concept of multi-asset poAMMs, where the poAMM accepts and stores multiple crypto assets instead of a single asset, could revolutionize liquidity provision and asset management within DeFi. This approach would allow protocols to diversify their reserve assets, potentially reducing risk and improving the financial robustness of the poAMM.
Final Thoughts
Opening up the token design space with poAMMs is more than just a step forward in Web3's maturation. It represents a paradigm shift toward a more autonomous, efficient, and sustainable ecosystem. By harnessing the power of dynamic bonding curves, protocols can now fully control their economic destiny, mitigating past inefficiencies while unlocking new avenues for growth and stability and allowing crypto projects to own a realistic portion of annualized DEX fees of $1.5B otherwise leaked to LPs, market makers, and secondary market DEXs. As crypto markets mature, we can expect these DEX fees to increase, representing an even greater opportunity for poAMMs. Super-efficient poAMMs can even challenge CEXs and tap into their annual trading volume of over $27T+. Moreover, Web3 projects can use their True Market Capitalization to generate additional revenue passively.
Protocol-owned AMMs are in the early stages of development and require extensive simulations to harden them for various market conditions. By focusing on advanced tooling and easy-to-use platforms, poAMMs will soon be ready for widespread commercial use.
Special thanks to Jeff Emmett for feedback and discussion.
If protocol-owned AMMs piqued your interest, please get in touch with me.
You can find me on Twitter, where I write about crypto and Avalanche-related topics.
Disclaimer: This article is for informational purposes only and should not be considered financial or investment advice. Always do your own research and consult with a professional before making any financial decisions. The views expressed here are my own.
