The importance of AMMs to DeFi can’t be understated. But AMMs are broken.
A core tenet of early DeFi Summer was the provision of AMM liquidity in the form of “LP Tokens” for inflationary governance tokens. AMMs are a key innovation of DeFi but suffer from many drawbacks.
Why are Legacy AMMs broken?
| Issue | Legacy AMMs |
|---|---|
| Providing Passive Liquidity is unprofitable (IL > Trading Fees) | Legacy AMMs on new ecosystems like Solana provide inflationary token rewards such as RAY or ORCA to incentivize liquidity provision. |
| Liquidity in a regular CPMM curve is shared from 0 to Infinity. | Constant Product AMMs share liquidity from 0 to 100, prompting Legacy AMMs introduced concentrated liquidity MM, which allows users to specify which range to provide liquidity to. This is equivalent to an actively managed liquidity position. |
| LPs rely on arbitrage to rebalance their pools to 50/50 | When pools get unbalanced, Legacy AMMs rely on arbitrageurs to purchase cheap tokens and sell elsewhere, bringing the internal price of the AMM in line with other venues. |
Solving this issue is crucial, as AMMs are the primary source of on-chain liquidity across many DeFi ecosystems today. If users cant make money providing liquidity without inflationary governance rewards, DeFi will always be limited in it’s growth.
In this piece, we will dive further into the struggles faced by legacy AMMs, and how Lifinity intends to tackle them. We will also look into Lifinity’s unique positioning as an NFT + DeFi project that delivers quality returns for its holders. Lifinity is innovative in tackling legacy DeFi issues and how it’s tokenomics are structured.
In regular constant-product AMMs, an LP token consists of 2 assets such as SOL/USDC. When traders want to buy SOL or sell SOL using USDC, they will trade against your LP token.
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When purchasing SOL, they will deposit USDC into the LP token and withdraw SOL, and vice versa. The price of SOL in this model is determined by the ratio of SOL and USDC. If there is 1 SOL and 10 USDC, the price of SOL is 1 SOL = 10 USDC.
This reliance of pricing on the intrinsic ratio of the LP token leads to impermanent loss. If the price of SOL is 1 SOL = 11 USDC elsewhere, arbitrageurs will purchase “cheap SOL” from your LP token and sell it elsewhere. It is the equivalent of getting punched whenever the market is moving.
Thus: Providing LP liquidity this way is frequently unprofitable.
How Lifinity fixes this:
Lifinity can utilize Pyth price feeds to adjust it’s price. Instead of offering 1 SOL = 10 USDC while other venues offer 1 SOL = 11 USDC, Lifinity can automatically adjust its price to 11 USDC in line with other venues.
While this reduces the volume that Lifinity captures, it avoids “Toxic Flow”, which primarily is arbitrageurs exploiting price variances between AMMs and centralized exchanges. The reduction of Toxic Flow allows Lifinity to avoid unprofitable volume, where the impermanent loss of providing liquidity is greater than the market making a profit.
As Lifinity’s price regularly matches that of centralized exchanges, arbitrageurs frequently arb onchain AMMs such as Raydium/Orca with Lifinity instead of waiting for deposits/withdrawals to clear with centralized exchanges.
Now that Lifinity has solved the problem of profitably providing liquidity, it’s time to scale it up. In traditional Constant Product AMMs, capital is shared across a curve from 0 - infinity.
However, logically speaking there is no way the price of a token will go between 0 and infinity regularly. This means that there is a lot of capital being inefficient on the edges, and it led to a new product called Concentrated Liquidity AMMs.
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