Decentralized Finance (DeFi) has experienced strong growth over the past year. The total value locked in DeFi DApps, on-chain trade volume, and popularity of DeFi tokens have all increased substantially.
Despite this growth, on-chain market making is still primarily limited to liquidity contribution by passive liquidity providers using Automated Market Makers (AMMs). Most professional market makers (or ‘manual’ market makers) have stayed out of market making directly on-chain, due to the lack of understanding of what on-chain market making is, the differences with off-chain models, and the complexities involved in getting started and running a profitable operation.
Over the past couple of years, Kyber Network has been facilitating professional on-chain market making for our in-house team and other market making teams. In doing so, we have gained a substantial amount of experience and expertise regarding how professional market making can work on-chain.
Professional market makers account for 70%-80% of all trade volume happening on Kyber, generating over US$1 Billion in on-chain trading volume so far. We are achieving close to 30 Bps of profit on average for our in-house market making operation, which far exceeds the market making industry norms in centralized exchanges.
In this article, we discuss the current state of on-chain market making, the opportunities in DeFi, and how we can help market makers get started in this exciting new ecosystem and achieve profitability.
On-chain market making refers to providing liquidity on-chain, which means that the token price quoting, order matching, and trade settlement all happens directly on the blockchain itself. The primary goal of these market makers is profiting on the bid-ask spread of the token trade. In the process, they help to ensure there’s enough trading volume so trades can be done seamlessly.
As its name suggests, off-chain market making refers to transactions that do not utilize blockchain technology in the quoting, matching and settlement process. These trades are conducted on centralized exchanges (CEX), with data recorded in centralized databases and servers.
Fully on-chain market making is also different from hybrid approaches, where the orders and matching are performed in an off-chain system (for example, 0x). There is a different set of opportunities and trade-offs, but the main concept to understand here is that many DeFi apps and use cases can only take liquidity from fully on-chain protocols.
Let’s consider an example of a transaction flow that can only be facilitated by market makers providing on-chain market making:
Imagine a user who wishes to perform a collateral swap in MakerDAO, changing out his ETH collateral for a different token like KNC. He can take an uncollateralized flash loan to initially repay the DAI debt, then swap his original ETH collateral with KNC before repaying the (DAI) flash loan — all performed entirely on-chain using smart contracts.
The process described above involves embedding the token swap as part of a sequence of smart contract functions. Since smart contracts only talk to smart contracts, decentralized DApps can only use on-chain liquidity to perform innovative smart contract-enabled DeFi functions such as flash loans, on-chain liquidation, and portfolio rebalancing.
As such, market makers who want to cater to these use cases, can only do so by provisioning on-chain liquidity.
In essence, these on-chain flows are often far more profitable than usual trading flows, with takers willing to pay more spread for the transactions to be completed in the same Ethereum atomic transaction. Also, lower professional competition (which we shall elaborate on soon) means competition is primarily limited to automated market makers or very thin orderbooks.
As a point of comparison, when using market making strategies on centralized exchanges, 1bps of profit per volume based on a high turnover is already considered a big return. This low profit margin is due to many liquidity providers and takers deploying a wide variety of different strategies, and because order placements and cancellations can be as fast as milliseconds and without cost.
In contrast, market making on-chain is currently far less competitive, with spreads and thus profit margin per volume higher on-chain. This means that Professional market makers can very often generate profits of close to 20-35bps on their on-chain volume. For example, Kyber’s FPR averaged about 35bps of profits per volume traded in 2019 (about 1.2M ETH).
Given these opportunities, and how off-chain liquidity can’t be used in DeFi, why isn’t on-chain market making by professionals more prevalent? The core reason is because the order book model, which works extremely well for market makers on centralized (off-chain) exchanges, has severe constraints when it is applied on-chain.
Challenges to Using the Order Book Model On-Chain
Professional market makers typically use off-chain order book exchanges for market making. However, when this order book model is applied on-chain, it becomes very gas and capital inefficient for market-making, especially if the goal is to market make for many tokens with frequent updates.
The on-chain order book model has the following issues:
- High transaction costs: Every order submitted has a transaction cost in the form of gas. This issue becomes even more pointed in times of very high gas costs
- High capital cost: Quote tokens usually need to be locked up for every trade and cannot be used for any other purposes.
- Higher risk factor: Adjusting the price is inconvenient; it takes time and has to be factored in the pricing
- No protection mechanisms: In times of volatile markets, there is no protection from arbitrageurs
These problems mean that while the order book model might be the best mechanism for off-chain purposes when it comes to trading and price discovery, it is mostly impractical for on-chain market making.
Automated Market Makers (AMM)
On-chain market making is currently dominated by AMMs, which are much simpler to use than order books. Although AMM-based platforms such as Uniswap have worked well for many retail investors, they have major shortfalls for professional market makers, due to a lack of capital efficiency and control over pricing strategies.
AMMs use a simple algorithm that automatically provides a tradable price, but offers no control over trading and pricing strategies. There is limited protection against “impermanent loss”, which is a term for losses that are not yet realized. With no control over the token price, AMM liquidity providers are exposed to the market and they need to hope that in the long run, the price will not deviate far from its original price point, yet still have enough volatility during the same period to increase the chance of profitability. It is not surprising that returns from AMMs can often be negative.
In addition, AMMs are very capital-inefficient, requiring a relatively high amount of token inventory ‘locked up’ to provide liquidity. AMMs can only provide sufficient liquidity for token pairs that are already sufficiently liquid to begin with.
As such, AMMs are of limited use to and are not suitable for professional market makers.
Kyber has developed a unique system called the Kyber FPR (Fed Price Reserve) that is tailor-made for professional market makers.
This FPR system focuses on allowing as much control as an order book system, while providing several key design features to address the issues mentioned above, manage risk more effectively, increase efficiency for on-chain market making, and help achieve profitability.
When market makers start to market make on-chain, they open themselves up to the world of possibilities in DeFi, which is impossible if interacting with DeFi at a hybrid or off-chain level.
Around the end of September, Kyber will be launching an exciting new initiative to complement our FPR. This will involve an end-to-end liquidity framework for market makers. The goal is to make it much easier and faster to onboard market makers to on-chain market making, provide all the tooling, education, and support they need, and launch an incentive program to help make the process as profitable as possible. This new initiative stems from months of research into this topic, as well as our work with the Chicago DeFi Alliance and the top professional market makers in the space today.
We hope this article explains the current state of on-chain market making and its opportunities and challenges. If you would like to learn more, please contact us. We would love to help you get started with on-chain market making!