Making sense of Defi concepts - AMM

-
Despite having heard about DeFi earlier, I have yet to explore this thriving crypto jungle. This post serves as a kick-starter.

Introducing one of the popular Defi application out there - AMM, which stands for Automated Market Maker (AMM).

What is an Automated Market Maker (AMM)?


General definition of a market maker by Investopedia:

A market maker is a individual market participant or member firm of an exchange that also buys and sells securities for its own account, at prices it displays in its exchange's trading system, with the primary goal of profiting on the bid-ask spread, which is the amount by which the ask price exceeds the bid price a market asset. It is typically a bank or financial institution.



In the DeFi space they have it automated, letting the community profit instead. Hoo ha!

"Not only can you trade trustlessly using an AMM, but you can also become the house by providing liquidity to a liquidity pool. This allows essentially anyone to become a market maker on an exchange and earn fees for providing liquidity."

Earning fees (yield farming) for providing liquidity sounds like cool stuff ya?

So let's try figure what's in it.


Read this or view the video near the bottom of this post.

Liquidity Pool explained


Liquidity pool is the "market place" where you have 2 or more of the assets in pools for traders to trade / swap. 

As a liquidity pool (LP) provider, you would supply the stipulated assets thus providing "liquidity" (as mentioned above) according to the rules of the smart contract in the protocol.


"Be wary of projects where the developers have permission to change the rules governing the pool. Sometimes, developers can have an admin key or some other privileged access within the smart contract code. This can enable them to potentially do something malicious, like taking control of the funds in the pool. Read our DeFi scams article to try and avoid rug pulls and exit scams as best you can."


On top of that, there is this concept of impermanent loss that could happen when you do LP. No free lunch in this world, duh!

So what on earth is Impermanent Loss? 

Ok here you go, click and read to unfluff the scramble eggs in your mind.

Impermanent loss curve



"Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them." (meaning you can make a loss when you withdraw your crypto from the pool.)


"As a simple rule, the more volatile the assets are in the pool, the more likely it is that you can be exposed to impermanent loss." 


If you don't want to crack your brain with calculations, here's an Impermanent Loss Calculator online to the rescue.


The Alice example in the article points to the fact that you could earn quick bucks as an arbitrage trader in a liquidity pool that has much liquidity yet not many sharks around (arbitrage traders that fight with you before the ratio balances to the market rate). On the other hand, a liquidity provider welcomes more traders (or high trading volume) as that would mean more trading fees earned for them.


What's arbitrage? When there's a spike in market price say for ETH, they can withdraw ETH from the pool to sell (outside) for spread profit and thus upset the pool's ratio. Since what determines the price of the assets in the pool is the ratio between them in the pool.


However, since your % of the pool owned remains unchanged, the change in pool ratio would then realize an impermanent loss when you withdraw from the pool. Theoretically speaking, the bigger the pool size, the lower is the risk of impermanent loss.


Do remember, where there's blood sharks will come...


"One last point is to look for more tried and tested AMMs. DeFi makes it quite easy for anyone to fork an existing AMM and add some small changes. This, however, may expose you to bugs, potentially leaving your funds stuck in the AMM forever. If a liquidity pool promises unusually high returns, there is probably a tradeoff somewhere, and the associated risks are likely also higher."


Here's a writeup about Uniswap (one of the very popular AMM)

Closing thoughts


Unless I am more capable of navigating these rules and their limitations, I will likely to remain on the sideline instead of jumping headlong into a pool that may be too deep for my "swimming skills". 

Maybe I can attempt to be a shark, but I certainly don't want to end up as the shark's fin on others' dish. (Everyone wants a bite of everyone's crypto... just like everyone wants a bite of everyone else's share of money when trading in the stock market.) 

Some bloggers who are making big and quick bucks may exhibit confirmation bias in their articles, thus, I would advise anyone who are interested in crypto venture to always exercise your own due diligence.


Lastly, don't get rekt!




Liquidity explained:




--
Do you know that what you can do in the Tradfi (traditional finance) world can be done in the Defi world as well? All through smart contract interactions.
  • Borrowing / Lending
  • Insurance
  • DCA (on platforms)
  • Value investing
  • "Dividend" investing (yield farming, staking)
  • Momentum trading
And there may be so much more...


What is Defi?

"DeFi refers to a system where software written on blockchains makes it possible for buyers and sellers and lenders and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction." - Investopedia



I can foresee DeFi's disruption to traditional bank services if it can provide stable infrastructures and ease of use for businesses and the masses to carry out financial transactions (lending, borrowing, trading, payment etc). If it has not already happened in some parts of the world. 


A side point to note is that banks are also jumping on the bandwagon of cryptocurrency. Hmm are we going to be seeing more crypto-derivative products in the near future? 

Bitcoins IOUs? Erm no thanks, it's like how I would rather hold gold than the gold derivatives.


Some risks to consider with Defi


"The DeFi ecosystem is still riddled with infrastructural mishaps and hacks. Scams also abound in the rapidly-evolving DeFi infrastructure. DeFi “rug pulls,” in which hackers drain a protocol of funds and investors are unable to trade, are common, though there are well-established protocols that can be used to reduce this risk significantly." 
- Investopedia


"There are an incredible number of risk factors piled up on top of each other in the world of DeFi apps. These apps are crudely glued together based on potentially-faulty smart contract code, trusted oracles, developer-controlled backdoors, volatile underlying network tokens (e.g. ETH, BNB), centralized stablecoins with plenty of counterparty risk, yields denominated in Ponzi-esque crypto tokens with unclear utility, and other problematic building blocks."
- How bitcoin and defi are completely different phenomena


Resources for newbies

To familiarize with the crypto terms...




-
I have been using Blockfi to earn some interest on my cryptos, which are of much higher rates than banks'. To visit my updated grumbles on DBS fixed deposit and their terms click here.

Undeniably, I have to undertake a bigger risk (mainly custodian risk) by not depositing in the SG banks or any MAS approved institutions. I take that as a trade-off for better yields.

GUSD interest rate on Blockfi is currently 8.6%. It's Cefi not Defi, in case you wonder. You can sign up with my referral if you are interested.

Blockfi's cash withdrawal is subjected to minimum of GUSD5000 per withdrawal. No minimum for GUSD withdrawal as crypto to other platforms. Subjected to only 1 free withdrawal per month.

Alternatively, you can transfer GUSD to Gemini and swap them to USD for trading or withdrawal.



Defi concepts to be continued...

Related posts: 


Like what you read? Follow me on Facebook or Twitter for updates and news that I dig.

Check out my referrals for fantastic sign up bonuses on SAXO, Moomoo, Gemini, Celsius, Blockfi and more.

🤗
Thanks for reading!

Comments

Post a Comment

Popular posts from this blog

The gold rush again

-
Image
I recently saw this video on CNA Money Mind channel https://www.channelnewsasia.com/watch/money-mind-2024-2025/going-gold-4299741 and thought I would summarize some learning points for those interested in gold investment. Photo by Zlaťáky.cz on Unsplash Gold is viewed as a safe haven asset in time of uncertainty, crisis or geopolitical risks. Demand for gold is influenced by Central bank purchases. The purchase premium of gold decreases in % with relationship to the gold bar's weight. Eg, a heavier gold bar has lower purchase premium over a lighter one. There's no GST for investment grade gold bars. Gold-backed ETF is backed by physical gold. Lower yield environment will benefit gold prices as the opportunity cost of holding gold lowers. Source: https://www.statista.com/statistics/673513/monthly-prices-for-gold-worldwide/ As seen from the chart, the last mega price spike was in year 2019 to 2020. This year we saw another mega spike. In order to circumvent any US withholding t
Read more

Shit happens and I lost my low-hanging fruits

-
My SAYE account has just hit its 25th month anniversary which is also the "month of maturity". Anticipating to get the 3.5% bonus interest for all these months of saving, I was shocked to see only $17+ cash gift credited as opposed to a few hundred dollars. I was about to send a message to query the bank what caused this interest plummet versus what I got in the 13th month when I came across a debit transaction in my account history (GASP!). To my oblivion and horror, I have accidentally selected my SAYE account to transfer $50 to a joint account to foot some bill in one of the months last year. Here's the terms and conditions for those who are not familiar with the SAYE account of POSB. "To receive the additional 3.5% p.a. Cash Gift Interest, ensure that you do not make any withdrawal from your POSB SAYE account." "If a withdrawal is made in the month, this will result in the previously accumulated additional 3.5% p.a. interest to be forfeited." Damn.
Read more

Letters of Administration / Probate - DIY application

-
Image
It's been almost 2 months since my mum's passing. I have not had the mood to blog as there's simply too much for me to settle - both tangible and intangible stuff.  For the first month, there's like a void in my life that I couldn't get used to because I was so used to the daily routine of taking care of her. It felt like a boulder lifted off my shoulder, as I was near breaking point; but this boulder was not gone, instead it shifted to my heart. The passing was sudden but not unexpected. My mum's condition deteriorated rapidly after her last fall, which led to hospitalization, and every hospitalization made her more frail. On the last discharge she could barely sit up in bed. My mum  did not leave behind a will  because she did not see a need to at that time when she still had a clear state of mind. Without a will, I would need to apply for the Grant of Letters of Administration (instead of a Grant of Probate ) in order to administer her Estates. (Note: If ther
Read more

Weekend brain food IX

-
It's been a while since I have posted weekend brain food. I have been quite out of touch with investment theories and research as I was pretty caught up with work, sports and events.  This is an old draft... very old yes. My thoughts part is recent. Benjamin Graham vs. Jesse Livermore  - by A Wealth of Commonsense "In chapter 8, Graham introduces the story of Mr. Market as a way to illustrate the manic behavior of investors in the short-term. Chapter 20 covers the idea of margin of safety as a way to better understand risk management. Both chapters still hold up to this day despite the fact that the book was originally published in 1949." "You can still learn from legendary investors and traders. Market history can still help give you insights into potential risks. But markets change. Investors adapt. Rules are updated. Advantages slowly get arbitraged away . Strategies that outperformed in the past don’t work as well in the future once everyone knows about them. Th
Read more

Reflections for year 2023

-
Image
2023 is a year which I have relented to the inevitable dealing with adversities. Sending my mother in and out of hospital had become a norm. Being a healthcare professional, I thought I could handle it single-handedly well enough, not until the point when my mother ceased to be fit enough to attend dementia day care that I came to the conclusion that I needed a helper. However, things took a steep downhill turn before I could hired one (counted myself lucky for it). My mother passed away in June, it was a relief for me and probably a relief for her as well. However, life is not meant to be smooth-riding. My mother did not leave behind a will, thus I have to apply for the Letters of Administration with the Court and as my sibling has mental disability, this led to some complexities which have yet to be resolved. Instead of hiring a lawyer, I decided to apply the LOA and MCA orders by myself through the Service Bureau. I am paying my time and convenience for it but that's fine as I
Read more

Disclaimer:

The contents of this blog are author's personal opinions and do not constitute advice to hold, buy or sell any securities, commodities or assets mentioned. I do not guarantee the accuracy and reliability of any information provided, and shall not be liable for any losses incurred from reading my posts or using the materials herein. This blog may contain affiliate links to external sites.