🤔Vision, Why & Gap

The vision, the why, current market gap and limitations of AMM

The vision

DerpDEX vision is to create an AMM that is on par with the performance of traditional MMs. DerpDEX runs on the lightning-fast Layer 2 (L2) zkSync, Base & opBNB chain, which removes the computational and gas cost bottlenecks facing AMMs on Layer 1 (L1) EVM mainnet.

Concentrated liquidity automated market maker (CLAMM) and Derp Market Maker (DMM) would be the first to utilise the full technical capabilities of zkSync, Base & opBNB to provide a high performance AMM with significantly improved LP returns and a more reliable trading profitability framework.

Under the current constant product market maker (CPMM) model, passive market makers are beholden to a basic pricing mechanism.

In its first version, DerpDEX introduces a better version of AMM for LP by combining concentrated liquidity market making (CLAMM) with adjustable fees pricing mechanism. This will incentivise arbitrageurs while protecting the P&L of LPs and reducing their impermanent loss risk profile.

Improving the performance of LPs would attract more liquidity. This would lead to traders enjoying greater liquidity, greater depth, more reliable trading during volatile periods, and reduced slippage. Subsequent DMM version will add volatility sensitive pricing and style price bands.

The "why" of DerpDEX

Before working on DerpDEX, we are a group of fintech developers, software engineers, product managers, traders and DeFi native builders. Observing how the DeFi market evolves, we are able to take the best of all the models to-date and launch a better product, better tokenomics and better execution.

The team envision DerpDEX as being the native liquidity layer on zkSync, Base & opBNB network, enabling value creation by working together with upcoming and existing protocols that need to solve the cold start liquidity and initial launch bottleneck, as well as long term solution to reduce costs to incentivise liquidity.

The gap in the existing market

One of the most significant advances of decentralised finance (DeFi) has been the evolution of decentralized exchanges (DEXes) along with automated market makers (AMMs). These decentralised protocols have turned passive savers into Liquidity Providers (LPs) for trading activities.

Traditional market makers (MMs) provide liquidity in centralised exchanges by posting bids and offers and dynamically managing their sizes and prices using complex mathematical models. This is a highly specialized activity reserved only for sophisticated players.

A more appropriate term for market makers is ‘price makers’ since they create ‘prices’ by showing bids and offers in the market. Traders that simply buy or sell at the bids and offers available in markets are termed ‘price takers’ as they simply take the prices provided to them by price makers. Price makers have to deploy capital in order to provide liquidity and they earn a return on this capital in the form of trading spreads when price takers trade against them. They buy at bids and sell at offer and theoretically pocket the difference.

AMMs allow passive savers to become LPs. Passive LPs provide the capital and get a return from trading fees without worrying about managing their positions actively. AMMs replace the sophisticated price making process of traditional AMMs with (relatively) simple mathematical frameworks that are based on the inventory of tokens in liquidity pools. This means passive LPs can leave assets in these liquidity pools and enjoy returns from market making activities that were earlier exclusively available to active market makers. This has created a new venue where investors can deploy their assets and earn a yield. This also means traders can enjoy abundant liquidity as more capital is deployed in liquidity provisioning activities.

Limitations of current AMMs

The current crop of AMMs is still way too simplistic when compared to their traditional market making cousins. The most popular form of AMM is the constant product market maker (CPMM), which arrives at ‘fair’ market prices by keeping the product of token inventory balances constant. It relies on arbitrageurs to step in and correct price misalignments with the broader market. In the process a lot of potential profits for passive LPs is left on the table. Sophisticated LPs that provide liquidity to AMMs do a lot of heavy lifting in the form of inventory management off-chain.

One big issue stopping AMMs from evolving closer to traditional MMs is the gas bottlenecks for performing sophisticated calculations on-chain. The entire market making framework and intelligence needs to be done on-chain so that passive LPs can enjoy similar returns to traditional MMs.

Another big issue is the constant fee model that AMMs deploy. AMMs have volatility exposure and the fees should be tied to the level of volatility in the market. When markets are moving a lot, LP profits are eroded away by higher impermanent loss. Sophisticated LPs that dynamically rebalance their token inventories bleed more money doing these rebalancings in volatile markets. Conversely, AMMs accumulate profits in calm markets when there is trading activity around a stable price. Constant fee fails to reflect these market dynamics.

This means LPs will be more inclined to take away liquidity from AMMs in volatile markets thus exacerbating market moves. In stable times, traders will be less inclined to pay the high fees on DEXes. This is the exact opposite of the desired dynamic! Volatility sensitive pricing is needed for incentivising LPs to keep funds during volatile times and traders to continue using DEXes in stable times. LPs should earn higher fees in turbulent times and lower fees in calmer markets. This would lead to a fairer and a more robust trading ecosystem.