Can AMM liquidity mining become a sustainable business model?

This article was published on ChainNews; Author: Cui Chen, employed at HashKey Capital Research; Reviewed by: Zou Chuanwei, Chief Economist of Wanxiang Blockchain.

AMM (Automated Market Maker) is currently the most popular trading model in the DeFi space. Unlike the order book pairing method, AMM uses a fixed product formula to calculate the tokens in the trading pool, allowing trades to be executed automatically and ensuring liquidity for trading pairs.

There are two participants in AMM: traders and liquidity providers (LPs). LPs inject a certain amount of tokens into the pool to provide trading liquidity while earning fees paid by traders. Generally, AMM protocols issue their own governance tokens, which are distributed to LPs as rewards for participating in the community.

For liquidity providers, the act of providing liquidity to earn returns is referred to as liquidity mining, especially in the context of obtaining the project's native governance tokens. This method is quite common in DeFi, as project teams use it to distribute native tokens to the true users of the community, who are the project's most genuine stakeholders. However, due to the existence of impermanent loss, LPs participating in liquidity mining cannot guarantee stable returns.

Whether the liquidity mining model can become a sustainable business model is a question that needs to be addressed in DeFi. This article analyzes the sustainability of liquidity mining in AMM from the perspectives of AMM traders and liquidity providers.

Trader Motivation

Compared to other trading methods, the main advantage of AMM comes from its complete decentralization. This is reflected in two specific points: a transparent trading method and censorship-resistant usage.

Unlike centralized trading platforms, in DeFi, users' funds remain in their own wallets during AMM trading, and trades are executed through contract interactions rather than traditional deposit and withdrawal methods. This helps avoid issues such as fraud and theft that can occur on centralized trading platforms. Censorship resistance is evident in both user identity and the trading pool; users can trade without undergoing KYC, and opening a trading pool does not require scrutiny, allowing many early-stage tokens to circulate through the establishment of trading pools. Thus, users can participate early or purchase potentially promising project tokens, leading to high returns.

The automatic execution of trades by AMM is also one of its advantages. AMM automatically exchanges tokens using a fixed product formula, ensuring timely trade execution and sufficient liquidity, even for large transactions.

The exchange rate in the AMM trading pool is passively changing; only trading actions can adjust the token exchange rate, with adjustments occurring at the Ethereum block time intervals. If there are changes in the off-chain exchange rate, they can only be corrected through traders' arbitrage actions to bring the trading pool's exchange rate back to normal levels.

In summary, traders are motivated to use AMM due to the transparent and decentralized trading method, high returns from early projects, and arbitrage opportunities between on-chain and off-chain.

Currently, the transaction fees for the two well-known AMM projects, Uniswap and Sushiswap, are both 0.3%, which is relatively high compared to centralized trading platforms, and users also have to pay additional gas fees on the Ethereum chain. Recently, gas fees have remained high, far exceeding trading fees, yet the trading volumes of Uniswap and Sushiswap continue to rank among the top in all cryptocurrency trading platforms. Rational traders will benefit more than their expenditures in this process, indicating that even with high fees, the demand for AMM among traders persists. Therefore, from the traders' perspective, the motivation to use AMM remains stable.

Liquidity Provider Motivation

Impact on Liquidity Provider Returns

Liquidity providers in AMM can be divided into two types: those who provide trading channels for small tokens and participants in liquidity mining; this section will only discuss the latter. The motivation of these LPs is clear: they are solely pursuing financial returns. Returns come from traders' fees and the project's native governance tokens.

In practice, LP returns are influenced by three factors: trading volume, native governance tokens, and the market value of the liquidity pool.

Trading Volume

Trading fees are a significant source of income for LPs, and this income entirely comes from traders' expenditures. Trading volume and fee rates are the indicators that affect trading fees; traders' exchange transactions will incur deductions based on the fee rate, and the deducted portion will remain directly in the trading pool. With a constant fee rate, the greater the trading volume, the more fees will be earned.

Native Governance Tokens

Projects distribute native governance tokens as rewards to the liquidity pool, which becomes another source of income for LPs. Factors affecting this income include the quantity and price of the distributed native tokens. The allocation of trading pool tokens and their quantity is determined by community voting. The distribution of governance tokens is done on a per trading pool basis; regardless of how the total amount of tokens in the pool changes, the quantity of governance tokens received within a certain time frame remains constant.

Receiving native tokens involves two steps: first, LPs deposit a corresponding proportion of tokens into the trading pool to obtain a certificate called LP Token; for example, depositing into the ETH - USDT liquidity pool will yield ETH - USDT LP Tokens. Then, LPs can stake their LP Tokens to receive a corresponding number of governance tokens based on their share of the total. The share of the liquidity pool held by LPs and the value of governance tokens will affect their returns.

Market Value of the Liquidity Pool

After depositing the corresponding tokens, liquidity pool providers receive certificates in the form of LP Tokens. When exiting, they can exchange these certificates for a corresponding proportion of the two tokens. Therefore, changes in the overall market value of the liquidity pool will also affect the overall returns for LPs.

The fluctuations in the market value of the liquidity pool come from two sources: changes in the composition of the liquidity pool and the price fluctuations of crypto assets. However, for liquidity providers, the initial principal will change due to price fluctuations of crypto assets, even without additional deposits into the liquidity pool.

This article discusses the sustainability of liquidity mining, focusing on the impact on LPs from providing liquidity, temporarily excluding the price fluctuations of crypto assets and concentrating on the effects of changes in the liquidity pool composition on LPs, namely impermanent loss.

When the token exchange rate changes, LPs will always incur impermanent loss because they are passively making opposite moves to the market. During the exchange rate change process, LPs are always selling tokens whose rates are rising and buying tokens whose rates are falling, with the rate change reflected in the proportion of tokens in the pool. To calculate impermanent loss, only the exchange rate changes at the moments of LP deposits and withdrawals need to be considered.

Liquidity Provider Return Calculation

Trading fees and governance tokens constitute the income of the liquidity pool, while impermanent loss represents the loss. Therefore, the returns of the liquidity pool can be calculated based on these three factors. Each LP's return rate is equal to the return rate of the liquidity pool. Clearly, if the fees and the distribution of governance tokens do not increase, the more tokens there are in the liquidity pool, the lower the overall return rate will be.

AMM Practice

Here, we will take the ETH - USDT trading pair in Uniswap and Sushiswap as examples to measure the actual returns for LPs after providing liquidity.

Currently, Uniswap has stopped liquidity mining, so LPs will not receive UNI distributions while providing liquidity; thus, only trading fees and impermanent loss need to be considered in Uniswap, while Sushiswap must consider the distribution quantity and price of SUSHI. The following data is from February 24 to February 25 over a 24-hour period.

Figure 1: Uniswap and Sushiswap ETH-USDT Trading Pair Interface

The ETH - USDT trading pair interface of Uniswap and Sushiswap displays the current token exchange rate, quantity, total value, and fee value in the pool. Therefore, we can calculate the initial proportions of tokens and the impermanent loss incurred based on the current quantities and exchange rate changes, considering the injection of fees into the pool.

Table 1: Calculation of Impermanent Loss for Uniswap and Sushiswap / USD

Based on impermanent loss, locked amounts, fees, and the value of distributed governance tokens, we can calculate the annualized return rate for LPs.

Table 2: Return Calculation for Uniswap and Sushiswap / USD

Among them, 77.3% of Sushiswap's annualized return comes from the distributed SUSHI token returns (calculated at a unit price of $15 on that day); this portion of returns will decrease after the price of SUSHI drops.

From the above table, it can be seen that even if Uniswap stops distributing tokens to the liquidity pool, LPs' annualized returns remain high, confirming the high trading volume of leading AMM trading platforms. On February 24 to 25, if income were solely from fees, Sushiswap's annualized return rate (17.0%) would be far lower than Uniswap's (60.0%); however, with the addition of governance token rewards, Sushiswap surpassed Uniswap. At the same time, Sushiswap's ETH - USDT pool locked amounts are higher than Uniswap's. This indicates that funds tend to favor projects with higher returns; if Sushiswap's locked amounts continue to increase in the future, its annualized return rate will decrease under constant fee and governance token income.

The distribution of UNI and SUSHI is based on project governance results and is a dynamic process. If the total returns and liquidity in the pool are not high, additional incentives can be provided through token mining. In the distribution of governance tokens, the total token supply will increase at a certain rate after the distribution is completed.

The annualized return calculations in this section are based on data from a 24-hour period, during which the volatility of ETH - USDT was around 6%. If the price fluctuations of ETH during other periods exceed this day's volatility and the fee levels are lower than those on this day, the annualized return rate for LPs will decrease, and vice versa.

Figure 2: Comparison of Liquidity and Trading Volume for Uniswap ETH-USDT Trading Pair

From the comparison of liquidity and trading volume for the Uniswap ETH - USDT trading pair, average liquidity has decreased since around October last year, while average trading volume has increased compared to October last year. If impermanent loss is not considered, LPs' income is continuously increasing and quite substantial. However, after October, the exchange rate of ETH against USDT rose significantly, peaking at a sixfold increase, during which LPs incurred substantial impermanent loss. If the exchange rate at the time LPs withdraw tokens approaches that at the time of deposit, then LPs will not be affected by impermanent loss.

Finally, it should be noted that the return rates in this article are calculated based on the assumption that the total amount of the liquidity pool remains unchanged. If calculating LP's return rates over a long time frame, the impact of LP deposits and withdrawals on the total amount of the liquidity pool also needs to be considered.

Sustainability of Liquidity Mining in AMM

For the trading methods of AMM, the demand for arbitrage both on-chain and off-chain, along with the high transparency and decentralized trading methods, will always exist, thus the demand from traders remains. However, for liquidity providers, there is motivation to participate only when profits can be made. According to the calculation methods for liquidity provider returns, these are primarily related to fees, the value of native governance tokens, and impermanent loss.

Impact of Fees

Fees are related to trading volume and fee rates, and users' trading volume demand comes from arbitrage and genuine trading needs. If the price of tokens fluctuates significantly, the demand for short-term arbitrage will increase. Genuine trading demand arises from users' preference for decentralized trading and the invocation of other DeFi applications. Ethereum gas fees will also affect users' trading preferences, as gas fees are generally considered part of the fees paid by users.

Value of Native Governance Tokens

The value of native governance tokens directly impacts the returns from liquidity mining, but their price is highly volatile, making it difficult to determine an accurate value range. Currently, several indicators can be referenced to determine the value range of governance tokens, including locked amounts, trading volume, and other functionalities.

Locked Amount

The locked amount can indirectly indicate the power of governance tokens; even though governance power does not mean having the right to use the locked funds, governance outcomes will affect the project's locked amounts. The locked amount represents the liquidity foundation of the project; generally, the higher the locked amount, the higher the value of governance rights.

Trading Volume

The amount of trading volume reflects users' actual usage; trading volume directly relates to LPs' income. Like locked amounts, the value of governance tokens cannot be directly linked to trading volume, but trading volume can reflect the project's valuation. Projects with higher trading volumes tend to have higher valuations, so increases in trading volume and users often indicate an increase in the value of governance tokens.

Other Functions

Tokens issued by centralized trading platforms generally have multiple functions, such as voting for new tokens, discounted trading fees, and paying gas fees for the exchange's public chain, all of which give platform tokens certain value. Although AMM governance tokens are not designed in the same way as centralized platform tokens, they will gradually incorporate additional functionalities. For example, in Sushiswap, only 2.5% of the 3% fee charged to traders is allocated to liquidity providers, while the remaining 0.5% is used to buy back Sushi, adding the value of fees to the governance token.

Impact of Impermanent Loss

For liquidity providers with costs in two types of tokens, impermanent loss is the only potential loss they may incur. According to the calculation method in this article, impermanent loss is only related to the proportion of tokens at the moments of LP deposits and withdrawals from the liquidity pool. If their token proportions are the same at these two time points, then LPs will not incur impermanent loss. Therefore, when the exchange rates fluctuate within a certain range, LPs can earn fee income without suffering impermanent loss. If the exchange rate rises unilaterally, the impermanent loss incurred by LPs may exceed their earnings.

Using call options or designing impermanent loss insurance are potential methods for controlling the scale of impermanent loss in the future.

Thoughts and Conclusion

The sustainability issue of AMM liquidity mining can be analyzed from the perspectives of the two participants: traders and liquidity providers. If the trading process benefits both parties, then liquidity mining can be considered sustainable. Traders' contributions are the trading fees and gas fees on the blockchain, while they gain arbitrage profits, a publicly transparent safety guarantee, and censorship-free trading.

For LPs, although they incur impermanent loss, they earn trading fees and potential rewards in native governance tokens. Currently, LPs' annualized return rates remain high; based on current fee income, LPs participating in liquidity mining can achieve substantial fee income. Token rewards are also a significant part; the quantity and timing of token rewards in the trading pool are determined by platform governance, making this method very flexible. The inflation model of liquidity tokens allows the issuance of tokens to continue, while project teams will design other mechanisms to lock tokens and create additional value.

This article calculates fiat currency return rates based on the premise that LPs' initial costs are in two types of tokens. If LPs' initial costs are obtained through borrowing, then LPs' borrowing costs and the changes in the overall market value of tokens also need to be considered. If the values of related tokens fluctuate, LPs will be passively affected because they cannot adjust their positions, and LPs' deposits and withdrawals incur significant fees. Therefore, few LPs use borrowing to obtain capital for liquidity mining; generally, LPs own both types of tokens for currency-based financial purposes. In this case, LPs need to pay special attention to the impact of impermanent loss, as significant price increases or decreases may lead to income that cannot compensate for impermanent losses.

In summary, liquidity mining in AMM is a sustainable business model. As DeFi continues to develop, the number of users utilizing AMM will increase. DeFi is still in its developmental stage, and ultimately, in a mature market, the return rates of various AMM projects will tend to be consistent and stable.