Market making in a nutshell
Market makers are in the business of providing liquidity to a market. There are three primary ways market makers make money: designated market making arrangements (traditionally paid by asset issuers), fee rebates (traditionally paid by an exchange), and by pocketing a spread when they’re making a market (what Uniswap does).
all market making is a battle against two kinds of order flow: informed flow, and uninformed flow. Say you’re quoting the BTC/USD market, and a fat BTC sell order arrives. You have to ask yourself: is this just someone looking for liquidity, or does this person know something I don’t?
If this counterparty just realized that a PlusToken cache moved, and hence selling pressure is incoming, then you’re about to trade some perfectly good USD for some not so good BTC. On the other hand, if this is some rando selling because they need to pay their rent, then it doesn’t mean anything in particular and you should charge them a small spread.
As a market maker, you make money on the uninformed flow. Uninformed flow is random — at any given day, someone is buying, someone is selling, and at the end of the day it cancels out. If you charge each of them the spread, you’ll make money in the long run. (This phenomenon is why market makers will
pay for order flow from Robinhood, which is mostly uninformed retail flow.)
So a market maker’s principal job is to differentiate between informed and uninformed flow. The more likely the flow is informed, the higher the spread you need to charge. If the flow is
definitely informed, then you should pull your bids entirely, because you’ll pretty much always lose money if informed flow is willing to trade against you.
(Another way to think about this: uninformed flow is willing to pay above true value for an asset — that’s your spread. Informed flow is only willing to pay
below the true value of an asset, so when you trade against them, you’re actually the one who’s mispricing the trade. These orders know something you don’t.)
The very same principle applies to Uniswap. Some people are trading on Uniswap because they randomly want to swap some ETH for DAI today. This is your uninformed retail flow, the random walk of trading activity that just produces fees. This is awesome.
Then you have the arbitrageurs: they are your informed flow. They are picking off mispriced pools. In a sense, they are performing work for Uniswap by bringing its prices back in line. But in another sense, they are transferring money from liquidity providers to themselves.
For any market maker to make money, they need to maximize the ratio of uninformed retail flow to arbitrageur flow.
But Uniswap can’t tell the difference between the two!
Uniswap has no idea if an order is dumb retail money or an arbitrageur. It just obediently quotes
x * y = k, no matter what the market conditions.
So if there’s a new player in town that offers better pricing than Uniswap, like Curve or Balancer, you should expect retail flow to migrate to whatever service offers them better pricing. Given Uniswap’s pricing model and fixed fees (0.3% on each trade), it’s hard to see it competing on the most competitive pools — Curve is both more optimized for stablecoins
and charges 0.04% on each trade.
Over time, if Uniswap pools get outcompeted on slippage, they will be left with majority arbitrageur flow. Retail flow is fickle, but arbitrage opportunities continually arise as the market moves around.
This failure to compete on pricing is not just bad — its badness gets amplified. Uniswap has a network effect around liquidity on the way up, but it’s also reflexive on the way down. As Curve starts to eat the stablecoin-specific volume, the DAI/USDC pair on Uniswap will start to lose LPs, which will in turn make the pricing worse, which will attract even less volume, further disincentivizing LPs, and so on. So goes the way of network effects — it’s a rocket on the way up, but on the way down it incinerates on re-entry.
Of course, these arguments apply no less to Balancer and Curve. It will be difficult for each of them to maintain fees once they get undercut by a market maker with better pricing and lower fees. Inevitably, this will result in a race to the bottom on fees and massive margin compression. (Which is exactly what happens to normal market makers! It’s a super competitive business!)
But that still doesn’t explain: why are all of the CFMMs growing like crazy?
Why are CFMMs winning?
Let’s take stablecoins.
CFMMs are clearly going to win this vertical.
Imagine a big traditional market maker like Jump Trading were to start market-making stablecoins on DeFi tomorrow.
First, they’d need to do a lot of upfront integration work, then to continue operating they’d need to continually pay their traders, maintain their trading software, and pay for office space. They’d have significant fixed costs and operating costs.
Curve, meanwhile, has no costs at all. Once the contracts are deployed, it operates all on its own. (Even the computing cost, the gas fees, is all paid by end-users!)
And what is Jump doing when quoting USDC/USDT that’s so much more complicated than what Curve is doing? Stablecoin market making is largely inventory management. There’s not as much fancy ML or proprietary knowledge that goes into it, so if Curve does 80% as well as Jump there, that’s probably good enough.
But ETH/DAI is a much more complex market. When Uniswap is quoting a price, it isn’t looking at exchange order books, modeling liquidity, or looking at historical volatility like Jump would — it’s just closing its eyes and shouting
x * y = k!
Compared to normal market makers, Uniswap has the sophistication of a refrigerator. But so long as normal market makers are not on DeFi, Uniswap will monopolize the market because it has zero startup costs and zero operating expenses.
Here’s another way to think about it: Uniswap is the first scrappy merchant to set up shop in this new marketplace called DeFi. Even with all its flaws, Uniswap is establishing a virtual monopoly. When you have a monopoly,
you are getting all of the retail flow. And if the ratio between retail flow and arbitrageur flow is what principally determines the profitability of Uniswap, no wonder Uniswap is raking it in!
But once the retail flow starts going elsewhere, this cycle is likely to end. LPs will start to suffer and withdraw liquidity.
But this is only half of the explanation. Remember: long before we had Uniswap, we had tons of DEXes! Uniswap has decimated order book-based DEXes like IDEX or 0x. What explains why Uniswap beat out all the order book model exchanges?
From Order Books to AMMs
I believe there are four reasons why Uniswap beat out order book exchanges.
First, Uniswap is extremely simple. This means there is low complexity, low surface area for hacks, and low integration costs. Not to mention, it has low gas costs! This really matters when you’re implementing all your trades on top of the equivalent of a
decentralized graphing calculator.
This is not a small point. Once next-generation high-throughput blockchains arrive, I suspect the order book model will eventually dominate, as it does in the normal financial world. But will it be dominant
on Ethereum 1.0?
The extraordinary constraints of Ethereum 1.0 select for simplicity. When you can’t do complex things, you have to do the best simple thing. Uniswap is a pretty good simple thing.
Second, Uniswap has a very small regulatory surface. (This is the same reason why Bram Cohen believes
Bittorrent succeeded.) Uniswap is trivially decentralized and requires no off-chain inputs. Compared to order book DEXes that have to tiptoe around the perception of operating an exchange, Uniswap is free to innovate as a pure financial utility.
Third, it’s extremely easy to provide liquidity to Uniswap. The one-click “set it and forget it” LP experience is a lot easier than getting active market makers to provide liquidity on an order book exchange, especially before DeFi attracts serious volume.
This is critical because much of the liquidity on Uniswap is provided by a small set of beneficent whales. These whales are not as sensitive to returns, so the one-click experience on Uniswap makes it painless for them to participate. Crypto designers have a bad habit of ignoring mental transaction costs and assuming market participants are infinitely diligent. Uniswap made liquidity provision dead simple, and that has paid off.
The last reason why Uniswap has been so successful is the ease of creating
incentivized pools. In an incentivized pool, the creator of a pool airdrops tokens onto liquidity providers, juicing their LP returns above the standard Uniswap returns. This phenomenon has also been termed “liquidity farming.” Some of Uniswap’s highest volume pools have been incentivized via airdrops, including AMPL, sETH, and JRT. For Balancer and Curve, all of their pools are currently incentivized with their own native token.
Recall that one of the three ways that traditional market makers make money is through designated market-making agreements, paid by the asset issuer. In a sense, an incentivized pool is a designated market maker agreement, translated for DeFi: an asset issuer pays an AMM to provide liquidity for their pair, with the payment delivered via token airdrop.
But there’s an additional dimension to incentivized pools. They have allowed CFMMs to serve as more than mere market makers: they now double as marketing and distribution tools for token projects. Via incentivized pools, CFMMs create a sybil-resistant way to distribute tokens to speculators who want to accumulate the token, while simultaneously bootstrapping a liquid initial market. It also gives purchasers something to do with the token—don’t just turn it around and sell it, deposit it and get some yield! You could call this poor man’s staking. It’s a powerful marketing flywheel for an early token project, and I expect this to become integrated into the token go-to-market playbook.
These factors go a long way toward explaining why Uniswap has been so successful.
That said, I don’t believe Uniswap’s success will last forever. If the constraints of Ethereum 1.0 created the conditions for CFMMs to dominate, then Ethereum 2.0 and layer 2 systems will enable more complex markets to flourish. Furthermore, DeFi’s star has been rising, and as mass users and volumes arrive, they will attract serious market makers. Over time, I expect this to cause Uniswap’s market share to contract.
Five years from now, what role will CFMMs play in DeFi?
In 2025, I don’t expect CFMMs the way they look today to be the dominant way people trade anymore. In the history of technology, transitions like this are common.
In the early days of the Internet, web portals like Yahoo were the first affordance to take off on the Web. The constrained environment of the early Web was perfectly suited to be organized by hand-crafted directories. These portals grew like crazy as mainstream users started coming online! But we now know portals were a temporary stepping stone on the path to organizing the Internet’s information.
The original Yahoo homepage and the original Google homepage
What are CFMMs a stepping stone to? Will something replace it, or will CFMMs evolve alongside DeFi?
These are great questions for posts to come 🙂