Research on the LP Mechanism of Various DEX Mainstream, AMM, and Cross-Chain

Exploring the LP Mechanism of Diverse DEX Platforms such as Mainstream, AMM, and Cross-Chain through Research

Author: Spike @ Contributor of PermaDAO

Reviewer: Lemon @ Contributor of PermaDAO

PermaDAO will start by deciphering the mechanisms of various DEX LPs, gradually revealing the complete operational model of DEX. The focus will be on introducing the unique advantages of Permaswap. This article is the first in a series and aims to provide readers with a macro-level understanding of various DEX LP mechanisms.

Definition and Characteristics of Traditional DEX

Traditional decentralized exchanges (DEX) are trading platforms based on blockchain technology that allow users to trade assets without relying on third parties. The characteristics of traditional DEX are as follows:

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• Decentralization: Traditional DEX operates on smart contracts and blockchain technology, providing higher security and transparency by eliminating the need for centralized exchange institutions.
• User Ownership of Private Keys: In traditional DEX, users have control over their own assets through their private keys, eliminating the need to store assets in the exchange’s wallets. This prevents the risk of user asset loss in the event of hacking or other security issues with centralized exchanges.
• No KYC: Traditional DEX typically does not require user identification or personal information, allowing for anonymous trading. This characteristic aligns with the decentralized nature of blockchain technology, protecting user privacy.
• Liquidity Challenges: Traditional DEX faces challenges in terms of liquidity due to the absence of centralized market makers. Since transactions are directly executed on the blockchain, there needs to be sufficient buyers and sellers for trades to occur. This may result in higher transaction costs on traditional DEX and limits its scalability and development.
• Smart Contract Risks: Trading on traditional DEX relies on smart contract execution. If there are vulnerabilities or attacks on the smart contracts, it may lead to user asset loss. Therefore, users need to carefully review the security of smart contracts and choose reputable traditional DEX platforms for trading.

Overview of Traditional DEX LP Mechanism

In traditional DEX, the LP (liquidity provider) mechanism refers to users depositing their digital assets into smart contracts to act as liquidity providers for trading pairs, in return for transaction fees and liquidity mining rewards. The LP mechanism typically adopts a proportional liquidity provisioning model, where users need to deposit both digital assets in a certain ratio into the smart contract to provide sufficient liquidity for the trading pairs.

The specific steps of the traditional DEX LP mechanism are as follows:

1. Users select the trading pair they want to provide liquidity for and determine the types and quantities of digital assets to deposit.

2. Users transfer the corresponding digital assets into the smart contract, becoming liquidity providers for the trading pair.

3. When users engage in trading, the smart contract automatically matches them with the corresponding liquidity providers from the liquidity pool based on their trade size and price. The transaction fees are then distributed to the liquidity providers proportionally.

4. Liquidity providers can withdraw their digital assets and exit the liquidity provider pool at any time.

The advantages of the LP mechanism in traditional DEX are:

• Decentralization: The LP mechanism in traditional DEX is based on blockchain technology, providing a decentralized trading platform without centralized intermediaries. Users can trade directly on the blockchain, have autonomous control of their assets, enjoy higher transaction privacy, and trade directly with smart contracts without providing personal identity information.
• Trading depth: Due to its decentralized nature, the LP mechanism in traditional DEX can avoid trading restrictions and audits from centralized exchanges. By providing liquidity pools, the LP mechanism in traditional DEX increases the trading depth, allowing users to trade within the liquidity pool, regardless of the trading pairs. This enhances trading flexibility and efficiency.
• Low cost: Users can participate in the operation of the exchange by providing liquidity and receive corresponding transaction fees and liquidity mining rewards. The LP mechanism in traditional DEX usually utilizes smart contracts to manage liquidity pools, reducing the involvement of intermediaries and lowering transaction costs. This allows users to trade at a lower cost.

However, the LP mechanism in traditional DEX also faces some challenges:

• Price slippage: Due to the limited funds in the liquidity pool, the LP mechanism in traditional DEX may result in price slippage when dealing with large-scale transactions, causing the obtained prices to deviate from expectations. Traditional DEX liquidity may be relatively low, leading to insufficient trading depth and significant price fluctuations.
• Transaction speed: The LP mechanism in traditional DEX, being based on blockchain technology, has longer transaction confirmation times and slower transaction speeds. It is not suitable for high-frequency trading or scenarios requiring quick execution.
• Liquidity risk: In the LP mechanism of traditional DEX, liquidity providers need to lock their funds in the liquidity pool, exposing them to liquidity risks. Significant market fluctuations may result in losses. The LP mechanism in traditional DEX poses specific risks to users’ digital assets, as there may be security vulnerabilities or issues with smart contracts that could result in asset losses.

Anatomy of an AMM DEX: LP mechanism

Definition and characteristics of an AMM DEX

An Automated Market Maker (AMM) is a common trading mechanism in decentralized exchanges (DEX) that uses liquidity providers (LP) to provide liquidity for trading pairs. It employs automated algorithms to match buy and sell orders, rather than relying on traditional order books. The main characteristics of an AMM DEX include:

• No need for centralized counterparties: An AMM DEX does not require centralized counterparties to provide liquidity. Instead, liquidity providers (LP) supply funds to the liquidity pool, acting as counterparties for trading.
• Use of common mathematical formulas to determine trade prices: An AMM DEX uses common mathematical formulas, such as the constant product model, to determine trade prices. This model relies on supply and demand relationships to determine asset prices and adjusts them based on trading volume and the amount of funds in the liquidity pool.
• Provision of liquidity mining mechanisms: To encourage users to provide liquidity, AMM DEX often offers liquidity mining mechanisms. LPs can inject their funds into the liquidity pool and receive transaction fees and token rewards in return.
• Faster transaction execution: Since an AMM DEX does not rely on traditional order books, the execution speed of transactions is typically faster. This is because trades are matched directly within the liquidity pool, without waiting for buy and sell orders to be matched.
• Decentralization and security: AMM DEX is a decentralized exchange built on blockchain technology, providing a higher level of security. Transactions occur on the blockchain, eliminating the need to trust third-party intermediaries. Users have direct control over their assets.

Overview of AMM DEX’s LP Mechanism

LPs can inject their funds into trading pairs so that users can trade in those pairs. In AMM DEX, the LP participation mechanism mainly includes the following aspects:

• Provide liquidity: LPs inject their funds into trading pairs to provide sufficient liquidity for users to trade. LPs can choose to inject a single asset or multiple assets, depending on the design of the trading pair.
• Fund pool management: LPs participate in managing the fund pool, including adding funds, removing funds, and adjusting fund ratios, etc. LPs can manage the fund pool based on market demand and risk preferences to maximize their profit.
• Earn fee income: As liquidity providers, LPs receive a portion of the trading fees as rewards. The distribution of fees may vary depending on the design of the AMM DEX, some may use fixed proportion allocation, while others may use dynamically adjusted methods.
• Risk management: LPs need to bear certain risks, including market volatility risk and liquidity risk, etc. To mitigate risks, LPs can choose to participate in multiple trading pairs to diversify risks. At the same time, LPs can adjust the fund pool allocation in response to different market changes.

By participating in the LP mechanism of AMM DEX, users can earn rewards provided by liquidity provision and participate in the management and operation of trading pairs. However, LPs need to bear certain risks and manage their funds in a timely manner according to market conditions.

Advantages and Disadvantages of AMM DEX’s LP Mechanism

1 Advantages:

• Decentralization: AMM DEX’s LP mechanism is based on smart contracts, without centralized exchanges, making trading more decentralized and transparent.
• Incentives for liquidity providers: By providing liquidity, LPs can earn a portion of the trading fees as rewards, incentivizing more users to participate in providing liquidity, thereby increasing market liquidity.
• Low barriers to entry: Anyone can become an LP by simply depositing funds into a smart contract, without going through tedious verification and authentication processes. This lowers the threshold for participation, allowing more people to participate in providing liquidity.

2 Disadvantages:

• Price slippage: Due to the fixed ratio fund pool mechanism of AMM DEX, when the trading volume is large, it can lead to price slippage, i.e., the difference between the trading price and the actual market price.
• Low capital efficiency: AMM DEX’s LP mechanism requires locking funds in the fund pool, which restricts the free flow of capital and reduces its efficiency.
• Exposure to contract risks: AMM DEX’s LP mechanism relies on smart contracts, so if the contract has vulnerabilities or is attacked, LPs’ funds may be at risk.

Cross-Chain DEX LP Mechanism

A Cross-Chain DEX refers to a decentralized exchange that allows asset transactions between different blockchain networks. Unlike traditional centralized exchanges, Cross-Chain DEXs use smart contracts to lock and unlock assets, enabling asset transfers across different chains. The characteristics of Cross-Chain DEXs are as follows:

• Decentralization: Cross-Chain DEXs adopt a decentralized architecture without a centralized exchange operator. Transactions are executed by smart contracts, ensuring openness, transparency, and security.
• Cross-Chain Transactions: Cross-Chain DEXs allow users to trade assets on different blockchain networks, such as conducting cross-chain transactions between Ethereum and Polkadot.
• Asset Locking and Unlocking: Cross-Chain DEXs use smart contracts to lock and unlock assets, ensuring the secure transfer of assets across different chains.
• Liquidity Providers: The liquidity of Cross-Chain DEXs is provided by users. Users can lock their assets in smart contracts as liquidity providers and receive transaction fees as rewards.
• Cross-Chain Bridging Technology: To facilitate the transfer of assets between different chains, Cross-Chain DEXs rely on cross-chain bridging technology to transfer and map assets between chains.

Overview of LP Mechanism in Cross-Chain DEXs

Cross-Chain DEXs are decentralized exchanges that allow users to trade assets on different blockchain networks. The LP mechanism of Cross-Chain DEXs aims to provide liquidity so that users can trade on different chains. Here are several common LP mechanisms in Cross-Chain DEXs:

• Atomic Swaps: Atomic Swaps are a type of atomic exchange technology that enables direct asset exchanges between different chains. In Cross-Chain DEXs, LPs can provide asset pairs from two different chains, allowing users to engage in direct inter-chain transactions.
• Wrapped Tokens: Wrapped Tokens are tokens that wrap assets from different chains into ERC-20 standard tokens. In Cross-Chain DEXs, LPs can provide trading pairs of wrapped tokens and assets from other chains, enabling users to trade on different chains.
• Bridge Protocols: Bridge Protocols are protocols that connect different chains, allowing assets to be transferred between them. In Cross-Chain DEXs, LPs can provide trading pairs of bridged tokens and assets from other chains, enabling users to trade on different chains through bridge protocols.
• Cross-Chain Liquidity Pools: Cross-Chain liquidity pools are mechanisms that pool assets from different chains together. In Cross-Chain DEXs, LPs can deposit assets from different chains into liquidity pools and provide corresponding trading pairs, allowing users to trade on different chains.

In summary, the LP mechanism of Cross-Chain DEXs aims to provide liquidity for users to trade assets on different chains. Different Cross-Chain DEXs may adopt different mechanisms, but they all aim to facilitate cross-chain asset transactions.

Advantages and Disadvantages of Cross-chain DEX LP Mechanism

The advantages and disadvantages of the Cross-chain DEX LP Mechanism are as follows:

Advantages:

• Greater liquidity: The Cross-chain DEX LP mechanism pools assets from different blockchain networks, providing greater liquidity. This means traders can easily find matching trading pairs and trade at better prices.
• Higher security: The Cross-chain DEX LP mechanism ensures asset security through smart contracts and multi-signature technology. This mechanism reduces the risks associated with centralized exchanges, making transactions more secure and reliable.
• Lower transaction costs: The Cross-chain DEX LP mechanism allows for decentralized trading, reducing the involvement of intermediaries and lowering transaction costs. This is particularly beneficial for users engaging in small-value and frequent trades.

Disadvantages:

• Slower transaction speed: The Cross-chain DEX LP mechanism requires asset transfer and confirmation between different blockchain networks, which may result in slower transaction speeds. In comparison, centralized exchanges typically offer faster transaction speeds.
• Limited trading pairs: The Cross-chain DEX LP mechanism requires the establishment of asset pools on different blockchain networks, which may result in fewer available trading pairs. In contrast, centralized exchanges usually offer a wider selection of trading pairs.

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