Concentrated Liquidity in DEX- Opportunities and Risks for Market Makers

This article summarizes the DeFi asset manager community meet-up in October 2022 in Zurich, Switzerland. The presenters included DeFi Solana protocols — Orca and Kamino, followed by the panel of professional crypto market makers — Amber Group, Sixant, and Kronos.

Professional asset managers are turning into digital assets and DeFi. Market making at crypto exchanges — sometimes called “yield farming” for certain exchanges- is one of the critical activities. How different is DeFi from traditional finance? What should you know before becoming a yield farmer? What advice seasoned crypto fund managers have for newcomers?

TL;DR

• With less capital, market markers can earn more fees on AMM DEX with concentrated liquidity (CLMM), as the capital is used more efficiently.
• Orca is the largest DEX on Solana in terms of traded volume, even though other DEXs on Solana have higher total value locked (TVL) in LPs. This example illustrates efficiency gains from CLMM vs. typical AMM.
• When you take an equity or FX trader and show him Binance or FTX, he will quickly get what is going on. It is the back office and operations behind DeFi, very different from TradFi.
• Know the risks you are exposed to. When you deposit money in DeFi, know the counterpart risk of a DeFi protocol or token.

DeFi vs CeFi vs TradFi

Let’s start by looking into CeFi, as it bridges DeFi and TradFi. When we want to buy crypto-currencies, we typically use centralized exchanges (CEX) to convert fiat money into crypto. As a next step, those crypto-currencies can be transferred into the crypto wallet and deployed to DeFi.

• TradFi — traditional finance — a conventional financial system that is not involved in crypto
• CeFi- centralized finance - financial intermediaries that offer services related to crypto, but they operate outside of the blockchain.
• DeFi- decentralized finance - financial applications that run on the blockchain
• CEX- centralized exchange - like Binance and Kraken — exchanges fiat currency into crypto and vice-versa.
• DEX- decentralized exchange — like Uniswap and Orca— swaps one token into another.

Order book vs. AMM

The typical stock exchange, e.g., NYSE, sets stock prices using the order book. This order book gathers all buy and sell orders and tries to match them. The stock price is the latest matched price. TradFi and CeFi exchanges use the order book.

In 2017, Vitalik Buterin, the founder of Ethereum, proposed a different approach, which Uniswap, the first DEX, later implemented. In this approach, called AMM — automated market maker, the mathematical formula determines the buy and sell prices. Sometimes it is also called CFMM — constant function market maker, because of the mathematical formula used:

x*y = k, where x — is the amount of token X, y — is the amount of token Y, k is a constant

Example: Let’s assume we have 1000 ETH (worth $1.5mn) and 75 wBTC (worth $1.5mn). With those tokens, we can create a liquidity pool (LP) of 1000 ETH and 75 wBTC, in which x = 1000; y=75; k=75'0000=1000*75 and price ETH/wBTC =x/y=1000/75=13.3. When somebody wants to buy 5 wBTC from the pool, x and y will be re-calculated: y=75–5=70; x=k/y=75000/70=1071 and the price set to ETH/wBTC = x/y = 1071/70=15.3

This is how UniSwap v2 and most of DEXs operate. In exchange for providing capital to the liquidity pool, its members receive part of the fees charged by DEX for executing the token swap. The process of delivering capital to liquidity pools is called yield farming.

Concentrated Liquidity

There is a trick in the AMM model presented above. The exchange price between ETH and wBTC is unlikely to change significantly. However, the capital locked in LP supports any price changes.

CLMM — Concentrated Liquidity Market Making — allows allocating capital in LP only to a specific price range, e.g., ETH/wBTC between 10.0 and 16.0, making using this capital more efficient. CLMM was pioneered by Uniswap v3 and implemented by Orca, the DEX on Solana, among others. Orca is the largest DEX on Solana in terms of traded volume, even though other DEXs on Solana have higher total value locked (TVL) in LPs. This example illustrates efficiency gains from CLMM vs. typical AMM.

With less capital, yield farmers on CLMM LP earn more fees as the capital is used more efficiently.

On the other hand, concentrated liquidity CLMM makes the market making more complex, as the price limits for each LP need to be specified. Luckily, there is a new DeFi protocol — like Kamino Finance — that automatically optimizes CL market-making. Check out this blog post to get started with Kamino.

Closing Thoughts from top Market Makers

Key takeaways from the panel discussion among experts from Amber, Sixant, and Kronos

Significant differences between TradFi and DeFi/CeFi

1. There are things that you are used to in TradFi, but they do not exist in DeFi, e.g., prime broker. You need to trade with DEXs directly.
2. In DeFi, you don’t have your account manager and must communicate via Discord. Though, this is slowly changing for the better in DeFi.
3. Crypto and DeFi trades 24/7
4. You are responsible for your tokens, which can be easily stolen or hacked. Beware of how you manage your private keys and wallets.
5. Getting prices from 120 sources in DeFi is a complex thing compared to 40 sources of US equity prices.

When you take an equity or FX trader and show him Binance or FTX, he will quickly get what is going on. It is the back office and operations behind DeFi, very different from TradFi.

Piece of advice for newcomers to DeFi asset management

1. One of the most important things — is to survive. Start slowly. It can be addictive, and it can be fun, but take it slow.
2. Put safety first. Trading from MetaMask is ok to at the beginning. Once you start putting more money — be careful with hot wallets.
3. Know the risks you are exposed to. When you deposit money, know the counterpart risk. When new to crypto, make trades with some returns and a reasonable risk profile. Beware of hidden counterparty risk.
4. Outsource much of the process that you can. Do not run everything yourself unless it is your core competency. Do not go all in, like in TradFi.

Thank you for reading. Share your feedback in the comments.

📌 Have a look at other blogs, e.g., CEX vs. DEX and impermanent loss

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