Decentralized Finance Industry (DeFi) apps give cryptocurrency owners the opportunity to make passive income. In most cases, users provide liquidity to DeFi protocols: lending crypto-assets to other users of the application. Decentralized Exchanges (DEX), and especially Automated Market Makers (AMM) are the protocols with the highest liquidity needs and highest transaction flow.
The rapid growth of the DeFi industry, whose applications have already locked up more than $63 billion in assets, has caught the attention of cryptocurrency users for a reason. A couple of years ago, experts expressed doubts about the expediency of the existence of decentralized cryptocurrency exchanges. By spring 2021, however, the largest DEXs – Uniswap, Curve and SushiSwap – were among the top 10 DeFi apps. And protocols can’t continue to evolve without a steady stream of users.
The more liquid an exchange is, the better it performs. Therefore, the protocols compete with each other to provide attractive offers for liquidity providers just as much as they compete for accessibility and simplicity of service for traders.
An overview of DeFi’s largest automated market makers will be useful to owners of crypto assets who are considering becoming a liquidity provider and generating revenue from it. This is not a comprehensive guide, but it will help both novice and experienced investors navigate the DeFi market and choose the most appropriate offer.
The choice of platform matters because in addition to providing their crypto assets to the app, the user becomes part of a community that has a voice. Apps work best when users have their say and participate actively in protocol development.
As a reminder, every potential investor in DeFi should independently research the industry’s offerings before committing money to a project.
How AMMs work
The basic principle behind automated market makers: Users do not trade with each other directly, but with a smart contract. AMM is always ready to buy or sell a crypto-asset at the closest price to the market;
Typically, an AMM is a series of pools of two assets, such as ETH and DAI. The price offered by the market maker is the value of cryptoassets in relation to each other. If there were 1 ETH and 2,000 DAI in the pool, 1 DAI would be worth 0.0005 ETH, and 1 ETH would be worth 2,000 DAI. However, if someone bought 0.01 ETH for 20 DAI, the price will change – now the DAI will be 0.000495 ETH. A tiny change, but the shift gets more serious as the size of the deals grows. Each transaction changes the base price. A big deal will knock the pool out of line with other markets, but you can rely on arbitrageurs to get it back on track. This is not a bug, but a feature of AMM.
In addition, automated market makers with enough pairs of crypto-assets can trade between any two crypto-assets from the listing site, even if they are in different pools. A user can trade BAT for ZRX, for example, selling BAT for ETH and then ETH for ZRX, all in a single transaction in a wallet program like Metamask.
This idea was first proposed by the developers of the Bancor protocol. After it was implemented by Uniswap, the concept proved to be a workable business model, and every major automated market maker developed its own iteration. Understanding how different protocols work can help a potential liquidity provider understand which DEX is best for them.
Uniswap
Uniswap is one of the market leaders. According to DeFi Pulse, the liquidity of the protocol exceeds $5.6 billion, making it the sixth largest application in DeFi. In May 2021, the developers of Uniswap launched a third
version of the protocol, which they envision will help the app become “the most flexible and efficient automated market maker ever.
The new version of the protocol solves the problem of wasted liquidity. Each transaction changes the price in the AMM pool, or rather, the price changes even within a transaction. In most cases it doesn’t matter, but if someone trades a significant amount of tokens in one pool, an amount that has a significant impact on the pool price, the final transaction price will be the average of a series of prices.
For example, the pool had 1 ETH and 2,000 DAI. If someone wanted to buy 0.5 ETH, the transaction would knock the price of ETH and DAI out of balance with the larger market. Such a transaction would have serious consequences, and it is unlikely that anyone would choose to make it. If no one wants to make trades that use most of the liquidity on one side of any pool, then no one will ever buy all the ETH or DAI in the pool. Only some of it can be sold – there is the problem of wasted liquidity.
Uniswap V3 created a different system in which liquidity providers are given more control over the price ranges in which their capital is used, with limited impact on liquidity fragmentation and gas inefficiency. Liquidity providers can set minimum and maximum prices for their share in any given pool. As conceived by the developers, this will lead to increased liquidity in the protocol. This enables traders to make much larger trades within the normal expected price range of a crypto-asset pair.
Stablecoins are the simplest example of why this system will make a positive difference to the app. One USDC should normally trade for 1 DAI because both are pegged to the U.S. dollar at a 1:1 ratio. However, in a simple AMM, a big deal can make a big difference in the price of both crypto-assets.
However, in Uniswap version 3.0, the trader will be able to require that his liquidity only participate in trades where DAI is sold for no more than $1.01 and no less than $0.99. If $1 million of liquidity is invested with this parameter, the trader can be guaranteed a trade of, for example, $500,000 with a price slippage of no more than a cent.
For small investors looking for passive income, working with Uniswap can be challenging, but the new system will be useful for all traders. The new version of the protocol may also have an effect on other platforms. For example, having concentrated liquidity positions on Uniswap means that the best trade execution most of the time will occur on Uniswap. The returns on passive liquidity providers in other applications will decline.
Some market experts are predicting new services that will take assets from retail investors and actively manage their placement on Uniswap to make it easier for ordinary people to access the leading decentralized exchange.
Other features
The advent of customizable pools will result in the ability for some traders to place buy orders at certain prices. For example, a trader can plan in advance to buy assets when the market declines. The developers of Uniswap call them “variable pools.
Uniswap version 2.0 introduces fast swaps
– The entire pool of tokens can be borrowed for the duration of a single Etherium transaction. In the last version of the protocol, the developers also introduced an oracle, or external price data source, which has been improved in version 3.0.
Uniswap allows liquidity providers to customize fees for pools in version 3 of the protocol so that they can, for example, charge higher fees for rarely traded pairs. Previously, transactions in all Uniswap pools had a commission of 0.03%.
Community
Uniswap was the last of the major AMMs to issue a
protocol control token.. When it happened in September 2020, The free distribution of UNI as a reward for each user’s participation in the protocol was one of the most important events at DeFi in 2020. Uniswap briefly launched a liquidity mining program to further distribute UNI as a bonus to liquidity providers in key pools. The program was then phased out as originally planned and has not been renewed.
Although UNI has risen significantly in value, as a management token it has not yet had much impact on the fate of the protocol. As of May 2021, there were only three proposals that UNI holders could vote on on Uniswap. Two of them failed, and one, the creation of a small grant program for the UNI community, was approved on December 26, 2020.
Uniswap is a venture capital-backed company. Apparently, the main protocol team plans to keep control of the application for a long time. In order for the final decision to take effect, at least 4% of
UNI to vote on any governance decision. Failure to reach such a quorum doomed two proposals in 2020.
The desire to maintain control is also reflected in Uniswap’s decision to restrict the use of Uniswap v3 source code for commercial or production purposes for two years, after which the protocol will be distributed under an open-ended GPL license.
SushiSwap
SushiSwap has a reputation as an AMM that is influenced by the community. While Uniswap is an automated market maker for insiders, SushiSwap has opened up its capabilities to a wider range of users and has never stopped distributing SUSHI management tokens to its liquidity providers.
SushiSwap launched at the end of summer 2020 during the DeFi boom. The developers used a clever concept, “vampire mining,” in which the SushiSwap team convinced Uniswap liquidity providers to hand over their crypto assets to the new app and allow the protocol to move all assets to SushiSwap.
SushiSwap was able to take out
liquidity from its “parent” platform to its own. As a result, the volume of blocked assets on Uniswap temporarily fell by 75%. However, after SushiSwap stopped extracting liquidity from Uniswap pools, Uniswap actually had more assets under management than when SushiSwap began its campaign.
Uniswap ended up back on top, while SushiSwap had a change in management and the protocol dropped significantly in the DeFi app rankings. Reduced rewards at SUSHI and then the debut of UNI led to the return of some liquidity providers to the original platform. As of May 2020, however, SushiSwap is still one of DeFi’s top 10 apps, and the value of blocked assets in the protocol reaches nearly $3.3 billion.
Unique Features
SushiSwap actively helps develop new projects with few tokens by promoting them through its Onsen system. Onsen pays additional rewards in SUSHI to those who contribute crypto-assets to it. This helps attract new users and builds loyalty to SushiSwap as some projects enter a new stage of development.
While Uniswap focuses on operating as a decentralized exchange, SushiSwap is expanding into other areas of DeFi. The protocol developers recently launched Bento Box, a capital pool to which other DeFi applications can connect. The first application on Bento was Kashi
– lending protocol that limits risk for collateral providers.
Combining a lending service with a decentralized exchange creates opportunities for long or short leveraged positions, but not only. Market experts suggest that the niche of Sushiswap could be the rapid launch of peripheral products built on top of mainstream applications. In addition, SushiSwap also plans to release a third version of the protocol in the near future.
In March 2021, Sushiswap developers launched
platform’s smart contracts on five new blockchains at once: Moonbeam Network, Binance Smart Chain, Polygon, Fantom, and the Etherium sidechain xDai. The project team also plans to launch an app of second-tier Etherium solutions, such as Optimism.
Additional Revenue
Uniswap and SushiSwap charge the same trading fees, but SushiSwap has never discontinued its liquidity mining program. Liquidity providers who place their crypto assets in Sushi Bar SushiSwap continuously earn SUSHI.
Community
SUSHI drives significant activity in protocol management. The SushiSwap community is considering quite a few suggestions, which you can see on the voting page. BentoBox is a good example: the idea originated
from a community member. When the proposal was approved, he developed it and now earns a small fraction of the app’s commissions.
Curve Finance
Curve is a protocol ahead of Uniswap in working with stabelcoins. Longtime runner-up Curve Finance surpassed
Uniswap in the value of blocked crypto assets and became the largest automated market maker in the DeFi industry.
Curve Finance has developed a new formula AMM specifically for pools with pairs of tokens whose price must change in sync with each other. The price of USDC and DAI, as well as USDT and TUSD should be pegged to the U.S. dollar at a ratio of 1:1 with small deviations. Similarly, the prices of WBTC and renBTC should shift largely in sync, because both represent “wrapped” BTC. The Curve was designed so that the price curve begins to shift at the far outer edges of the liquidity bands.
One of the key differences between Curve’s design and Uniswap or SushiSwap is that the protocol more easily handles pools with multiple tokens. This made Curve useful for the DeFi Yearn Finance protocol because it had strategies that allowed users to generate income from all the major stablcoins: DAI, USDC, USDT and TUSD. The proof of deposit in these strategies were tokens called, for example, yDAI and yUSDC.
Curve created a special pool to make it easy to switch between the four pools. In addition, users who intend to follow the HODL strategy for a particular Yearn token can still deposit Curve liquidity and receive a transaction fee.
Curve has carved out a niche for trading crypto assets that are not volatile relative to each other. “We have pools for volatile pairs that are in the last stages of audit,” states protocol creator Mikhail Yegorov. This means that Curve is ready to directly confront other AMMs.
One of the Curve team’s main ideas is to implement the concept of metapools – running pools for pools. The developers of the protocol also plan to expand outside of Etherium. In February 2021, the app team announced plans to launch the platform on the Polkadot blockchain.
Managing token
Similar to SushiSwap, Curve users can boost returns by getting a CRV protocol management token – Curve launched a liquidity mining program in August 2020. Liquidity providers in Curve pools can earn CRV, but the protocol distributes more tokens to users who have been delivering liquidity longer. This system can only be profitable if it delivers large amounts of liquidity.
Community
The primary management activity for CRV holders is deciding how much CRV is earned by
Liquidity providers for the various pools. This is one of the ways to attract new liquidity to the platform. For example, when USDT became popular on Etherium, early pool yields were extremely high as the protocol tried to fill the pool. However, as it has been filled and CRV distributed, the returns have become more reasonable.
Curve’s protocol management system is complex. For example, voting doesn’t happen with CRVs themselves-the supply of liquidity accumulates veCRVs in users’ accounts, which have no value except for the fact that they can be used to vote.
Bancor
Bancor pioneered the basic AMM model, but throughout 2020, when the value of blocked assets in other applications reached several billion, the protocol was stuck at a few million. However, that changed at the end of the year, and as of May 2021, Bancor is one of the top five largest decentralized exchanges with more than $1.5 billion worth of blocked crypto assets.
The protocol offers advantages for liquidity providers, such as one-way liquidity, which is unique to the sector. Most automated market makers require the user to provide two crypto-assets equal in value in dollars. Some AMMs automate the exchange of half a deposit to another crypto-asset, but the user pays a transaction fee, which in spring 2021 in Etherium reached
$70.
Bancor issues the required amount of its own BNT token instead of the exchange. When AMM connects each asset with its token, it simplifies transfers between any two crypto-assets in the service listing. If a user wants to exchange WBTC to BAT, Bancor can simply exchange WBTC to BNT and then BNT to BAT. To the user, it looks like a single transaction.
The protocol can issue BNTs as needed to create the second half of any deposit in the pool. The Bancor team calls it co-investment with liquidity providers. Essentially, all BNT holders pay a small amount as the supply increases for each new liquidity provider.
But it probably pays off as more liquidity providers improve Bancor’s performance, which means more demand for BNTs. This should favorably affect the price of the token in the long term. The most obvious problem is the effect of the issue on the price of BNT for its holders in the short term. Bancor also has a program to create deflationary pressure on the token by burning some of the commissions.
Unique Characteristics
In addition to one-way liquidity, what makes Bancor unique is that it solves the problem of floating loss or intermittent loss. If the value of one crypto-asset in the pool decreases compared to another, the value of the liquidity provider’s deposit may decrease in fiat terms, even if the total deposit in the underlying crypto-assets increases. Floating loss is one of the main problems for AMM.
To reduce the impact of this problem on the protocol, Bancor has developed an insurance contract. Users who take a floating loss on Bancor are guaranteed to retain the full amount of liquidity in terms of the value of their original deposit if they remain in the pool for at least 100 days. The Thorchain protocol, discussed below, has implemented a similar model.
Bancor has also launched limit orders. This is a common feature on centralized exchanges, but it is not present in many AMMs, mainly because traders experienced enough to apply limit orders use trading aggregators, such as Matcha and 1inch, to achieve the same result.
Bancor is a multi-network project. The decentralized BancorX application
allows you to switch between EOS and Ethereum networks.
Liquidity providers that put earned commissions back into pools can receive increased rewards over time. This encourages liquidity providers to stay in the pool longer.
Community
Bancor is managed through Bancor’s DAO. Voting takes place among holders of the vBNT protocol control token, a derivative of the BNT token that can be earned by delivering liquidity. The latest version of the management model was launched at the end of March 2021.
Thorchain
Thorchain is one of two AMMs in this review that does not work on Etherium. Outside of Ethereum, AMM activity is low. The outlook for Thorchain is still unclear – it is a relatively new protocol, launched
April 2021.
Thorchain takes a very different approach to settlement than any of the above protocols running on Etherium – it trades directly between blockchains. Thorchain is based on the Tendermint consensus algorithm, like the Cosmos blockchain. Thorchain uses mechanics very similar to those first used by Bancor.
Other protocols exchange crypto-assets within the blockchain on which they operate. Some can make transactions between blockchains, but use workarounds to do so.
Thorchain has its own blockchain, originally designed to function in multiple architectures. Like Bancor, it uses its own RUNE token to make transactions, such as between BTC and ETH. However, unlike Bancor, it does not offer users a “wrapped” (synthetic) version of the crypto-asset. A trader can put BTC into Thorchain from his wallet and get ETH into an Etherium wallet.
Like Bancor, Thorchain offers a floating loss guarantee for deposits made for at least 100 days. At the time of launch, the protocol team noted that temporary losses rarely occur when liquidity providers remain in the pool for such a long period of time. However, this does not guarantee complete protection against floating losses.
Managing Token
RUNE is a management token, as well as an instrumental network token. Users earn recently released RUNEs for acting as liquidity providers. The amount of RUNE that goes into each pool depends on how much income was generated from that pool in that block. The freshest RUNEs go to the most active pools.
Community
The team that came together around the creation of Thorchain decided to remain anonymous and avoid attention as much as possible. The developers have set a goal of handing over control of the project to RUNE holders in the summer of 2022.
PancakeSwap
As of May 2021, Coingecko’s decentralized exchange ranking, PancakeSwap is
first place with a daily trading volume of $7.84 billion, while Uniswap is in second place with $3.7 billion. The Defistation website estimates that the value of blocked crypto-assets in the protocol exceeds $9.8 billion.
PancakeSwap is a fork of Uniswap, created on Binance Smart Chain (BSC). The BSC operates on the Proof of Staked Authority (PoSA) consensus mechanism, with 21 active validators selected daily by the Binance Chain, a network operated by only 11 validators. BSC validators block for BNB steering. However, some analysts have raised concerns
about the centralization of validators, which are controlled by the Binance exchange. This model makes the BSC faster and cheaper to use, but significantly more vulnerable to hacking.
BSC is compatible with Ethereum smart contract logic, which makes it easier to run forks of successful Ethereum projects on BSC. PancakeSwap is an example of this. In mid-April 2021, however, the protocol ran into problems, leading to a temporary halt.
Supplemental Revenue
As with other AMMs, PancakeSwap liquidity providers earn commissions on transactions within the pools in which they participated. Since trading volumes on PancakeSwap are very high and transaction fees are much lower than on Ether, activity in the protocol should increase, allowing participants to make more profits. Liquidity providers also receive a CAKE control token.
Community
The PancakeSwap community is quite active in protocol management. Mostly participants approve of increasing CAKE rewards for new pools to get early liquidity and increase user interest, similar to the SushiSwap Onsen program. CAKE owners also decide how to change
transaction fees and how to distribute them.
Notes
Bits.media’s editorial staff reminds us that crypto-asset owners must make their own decisions about participating in DeFi’s automated market makers as liquidity providers. DeFi applications allow you to earn additional income, but they have risks that you should be aware of before you put your crypto assets in the protocol pool.
Any protocol can be hacked, prone to bugs, vulnerabilities and bad behavior by the project team. The above information is current as of mid-May 2021. Market conditions can change rapidly, and you should research each DeFi app yourself before using it.