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DeFi projects have been toying with different liquidity solutions, motivated by creating more efficient and convenient solutions than order books. While automated market makers (AMMs) helped to counteract some drawbacks of centralized exchanges' approach, they also hide several complex challenges users and liquidity providers should consider.
An AMM is a self-governing protocol that automates the process of matching orders, utilizing liquidity pools to facilitate continuous trading. These pools consist of crowdsourced pools of coins and tokens locked in smart contracts, meaning that DEXes rely highly on users to provide needed liquidity.
Besides attracting enough liquidity providers, ensuring those pools are always balanced is critical, as an imbalance can lead to intermittent trading. Moreover, the crypto market's high volatility affects swaps via AMMs from two sides. From the liquidity providers' point of view, it can cause losses while providing assets in pools. From the users' perspective, it can negatively impact the outcome of trades. Lastly, the growing popularity of DEXes and scalability issues on many networks lead to problems associated with high gas costs. Let's look at those issues more closely.
The poor concentration of liquidity in specific pools and the imbalance between liquidity pairs can pose substantial risks to users of decentralized exchanges. When the liquidity is imbalanced, some pools or assets may have much more liquidity than others, making it challenging for traders to swap assets at favorable rates and in an adequate time frame. The longer pools remain imbalanced, the longer the DEX's system works unreliably, causing dissatisfaction among users and their possible outflow to other platforms.
Even though AMMs are designed to balance pools automatically, rebalancing can sometimes be problematic due to unfavorable market conditions and the unavailability of sufficient liquidity (Learn more about liquidity struggles in this post). So, it is recommended to pay attention to available liquidity and market situation during trading and use tools that can help to protect from disadvantageous trades.
The soaring popularity of decentralized platforms comes with a notable challenge: high gas fees. This phenomenon, driven by networks' congestion and excessive demand, negatively affects user experience and prompts critical reflections on scalability solutions currently being developed or implemented to resolve this issue.
The problem of high gas costs is strongly linked to scalability issues that many networks are experiencing nowadays. An overwhelming demand for transactions, which exceeds a network's capacity, can result in notable delays. Consequently, slow and unpredictable transaction execution can negatively affect both traders and liquidity providers, hindering their ability to make use of profit opportunities coming their way.
Furthermore, high gas fees can create a lack of inclusivity by excluding users who find high gas costs especially unbearable, mainly small-scale traders. For them, trading on DEXes may sometimes be completely uneconomical. Therefore, it can limit their access to DeFi products and services, restricting their ability to take advantage of opportunities present in the DeFi space.
The AMMs' pricing mechanisms constantly work on rebalancing pools and calculating adequate pricing, which sometimes can cause problems, one being impermanent loss (IL). IL is the difference in value over time between depositing tokens in a liquidity pool and holding them in a wallet. This loss occurs when the market price of tokens inside liquidity pools diverges in any direction, making liquidity provision unprofitable.
IL concerns many liquidity providers who are thus hesitant to take part in a market and take a bet against volatile conditions. This risk is even more notable when the price of the assets in the liquidity pool experiences substantial fluctuations. In order to avoid impermanent loss, some traders even opt for other methods of providing liquidity, like using traditional order books or participating in liquidity pools with different risk-reward dynamics or some sort of insurance against IL.
The complete elimination of impermanent loss in pools is proved to be impossible. However, there are steps that providers can take to minimize this risk. For instance, they can choose to stake stablecoin pairs, whose prices typically fluctuate just a little. Doing so can greatly reduce the volatility risks, but providers' profits may also be notably smaller than with volatile assets.
Besides stablecoins, choosing pairs without a history of instability or high volatility is also a great idea. Conducting thorough research and selecting assets with a proven track record of maintaining their value is essential. This way, liquidity providers will be able to provide liquidity with confidence, knowing that their investment is relatively safe from market volatility.
The rates at which trades are executed are another hidden risk of AMMs. There are two aspects crypto users should pay great attention to: price slippages and MEV. Price slippage is a term that describes the difference between the price a trader expects to receive for an asset and the actual price at which the trade is executed. This variance occurs due to the liquidity pool's limited availability of required assets. The impact of slippage can be pretty significant, particularly for large trades. It can result in unpredictable costs for traders and lead to suboptimal execution prices, harming their trading strategies.
MEV (Maximal Extractable Value) is the highest value that can be extracted from manipulating transactions during block production. This term often refers to the profits that traders can gain by rearranging awaiting transactions. Since AMMs make pending transactions public before execution, MEV searches receive an excellent chance to exploit transactions waiting in the mempools (learn more about MEV in this post). Any manipulations with transactions can lead to notable price changes, negatively affecting targeted traders. It means traders with advanced knowledge of upcoming transactions may take advantage of the situation. Additionally, slippage can occur, which can impact the executed price.
Such risks can lead to financial losses, ultimately eroding trust in the fairness of the DeFi trading environment. These risks are even more severe during periods of high volatility or when interacting with pools with low liquidity. Traders concerned about MEV attacks and price slippage may choose to use platforms with more advanced security measures, including Kinetex, or employ alternative trading methods that offer better protection against these risks (limit orders, P2P trading, etc.).
AMMs have been a helpful tool in DeFi, which once transformed decentralized trading, providing users more flexibility. However, it is essential to acknowledge the hidden issues of this approach, such as MEV attacks, IL, etc., that require innovative solutions. As the DeFi community navigates these complexities, a concerted effort toward research, development, and risk mitigation will be crucial to ensuring the long-term sustainability and resilience of AMMs, associated solutions, and the DeFi ecosystem as a whole.
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