Hidden Problems of Automated Market Makers

Dubai, UAE, 10th January 2024, Decentralized finance (DeFi) projects have been experimenting with various liquidity solutions as they strive to develop more streamlined and user-friendly alternatives to traditional order book systems used on centralized exchanges. Automated market makers (AMMs) have emerged as a popular solution. However, it does not mean that they work without their challenges, which users and liquidity providers alike must take into account. Let’s look at some of them.

Pool Imbalance

The sufficient amount of available liquidity in pools and the balance between liquidity pairs are vital for successful trading using AMMs. When liquidity is imbalanced, trading crypto assets at advantageous prices and within a reasonable time becomes impossible. If pools remain imbalanced for long, the DEX system may become unreliable, provoking discontent among traders and driving them to other platforms. 

Despite the automatic rebalancing of pools by AMMs, the process can sometimes be challenging due to unfavorable market conditions and insufficient liquidity. Therefore, it is vital to exercise caution, remain aware of market trends, trade on trustworthy decentralized platforms, and leverage protective tools to guard against unfavorable conditions.

High Gas Costs

High gas fees have become a big issue for decentralized platforms due to their increasing popularity. This problem is mainly caused by the congestion and excessive demand on networks and naturally has a harmful influence on user experience. Significant delays can occur when an overwhelming demand for transactions exceeds a network’s capacity. As a result, there is a growing need to reflect on the scalability solutions currently being developed or implemented to address this problem.

In addition, high gas fees can create a sense of exclusion in the DeFi market by making it difficult for small-scale traders to participate. In some cases, trading on DEXes may be completely uneconomical for them. As a result, they may turn from the DeFi space, limited in their abilities to benefit from DeFi products and services.

Impermanent loss

Impermanent loss (IL) is another severe problem that liquidity providers constantly face. IL occurs when the value of tokens deposited in a liquidity pool diverges from one if holding them in a wallet over time. This value discrepancy makes liquidity provision risky and sometimes highly disadvantageous, worrying many liquidity providers who are thus hesitant to engage in a market with volatile conditions.

Although it is impossible to eliminate impermanent loss in pools completely, liquidity providers can take steps to reduce the risk. Some providers choose pools that offer some insurance against IL and good incentives. Others, with lesser risk tolerance, prefer staking stablecoin pairs, as their prices typically fluctuate very little, thereby considerably reducing volatility risks. However, such a tactic may also reduce profits considerably, too. 

Choosing pairs with no history of instability or high volatility is also a sound strategy to minimize IL risk. Conducting thorough research and opting for assets with a record of retaining their value is paramount. It ensures that liquidity providers can confidently offer liquidity, as they know that their investment is relatively protected against market fluctuations.

Price Slippages & MEV Attacks

Price slippages and MEV are two concealed risks of AMM that crypto users need to pay special attention to. The first refers to the difference between a trader’s expected price for an asset and the actual price of a trade. This difference arises due to the limited availability of assets in the liquidity pool. The second term (MEV) refers to the highest profit traders can obtain from manipulating transactions during block production. It is possible because AMMs make transactions public before execution, allowing so-called MEV searches to exploit transactions waiting in the mempools. 

These risks can ultimately lead to financial losses, eroding trust in the fairness of the DeFi trading environment. Traders concerned about MEV attacks and price slippage may prefer to use decentralized exchanges with advanced security measures or explore alternative trading methods that offer better protection against these risks.

Conclusion

AMMs have proven to be a valuable tool in the realm of DeFi, revolutionizing decentralized trading and offering users greater flexibility. Nonetheless, it is important to recognize the underlying problems of this approach, including issues such as IL, gas costs, MEV attacks, and others, which demand novel solutions. 

As the DeFi community navigates these problems, a concerted effort toward creating innovative, effective, and risk-free solutions will be imperative for ensuring the long-term sustainability and resilience of many DeFi platforms, not only those using AMMs. The Kinetex team supports this sentiment and is working on introducing solutions that make swapping crypto safer and more straightforward, such as the upcoming Flash Trade. 

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