Vitalik, vampires and the birth of Decentralised Finance

Here’s something that could only happen in crypto.

A guy gets fired from his job, stumbles on a random reddit post, learns to code… and one year later creates the most important decentralised finance project in history.

How important?

Well, since its inception in 2018, it’s handled roughly $2.2 trillion in transaction volume – which is more than the GDP of Canada, the world’s 9^th largest economy.

So, I’d say pretty important.

But let’s backtrack a second. Because I can see this sounds, maybe a little farfetched.

So…

The “guy” in question is Hayden Adams.

The random reddit post was written by none other than Vitalik Buterin – Ethereum’s co-founder/spiritual lord and saviour.

And the project is Uniswap – the world’s first truly decentralised Automated Market Maker (AMM).

Ah, “but what’s an AMM?” I hear you ask.

Well, you’re in luck, because AMMs are the subject of this issue.

So, strap in, because it’s going to be a fun one.*

What is an AMM and why were they such a milestone?

In a normal exchange, you have a person buying and a person selling. 

The person buying says what price they’re willing to pay by putting up a “bid”.

And the person selling says what price they’re willing to sell for by putting up an “ask”.

The gap between these two prices is known as the bid-ask spread.

In a market with lots of liquidity – lots of people wanting to trade on each side – the bid-ask spread will be inconsequential. 

But in a market with low liquidity, the bid-ask spread can be huge. And sometimes there isn’t even enough liquidity to make the trade at all.

So, on a big exchange, the ETH/USDC market will have extremely high liquidity.

But if you’re trying to trade a new, relatively unknown crypto, you can run into major issues.

Let’s say you want to buy or sell some new crypto called NEW.

You go onto an exchange and you see the order book looks like this:

The highest “bid” is 1 NEW to 1 USDC.

The lowest “ask” is 2 NEW to 1USDC.

So if you want to sell 1,000 NEW, you’ll have to accept 1,000 USDC for them.

But if you want to buy 1,000 NEW, you’ll have to pay 2,000 USDC for them.

See how low liquidity can be a problem?

And although liquidity and volume aren’t the same thing, they are proxies, so a market/exchange with high volume will also have high liquidity.

This is why – all else being equal – the more volume an exchange has, the more popular it becomes. Because both buyers and sellers get better deals when they trade.

Now, in traditional finance, you have “market makers”. 

These are people (more commonly big investment banks) that have large quantities of each side of the trade.

So, in the example above, they’d have a lot of NEW and a lot of USDC.

And they literally “make” the market by offering to buy and sell each side of the trade. It’s their job to keep the bid-ask spread small by providing a ton of liquidity.

And they make money by pocketing the bid-ask spread on each trade.

It’s probably important to note here that it’s not in a market maker’s interest to increase the bid-ask spread to try make more profit.

They make a lot more profit by keeping the spread small, which encourages more people to trade… which leads to bigger profits for them through high volumes.

(I also imagine it would be illegal for them to try increase the spread in a regulated market.)

Now here’s the thing. Market makers are middlemen. 

They make a lot of money just by merit of already having a lot of money.

But they are providing an important service, so I guess we’ll let them off this time.

Why don’t you have market makers in crypto?

You do. But they only operate on centralised exchanges. Not on decentralised exchanges.

The problem with trying to port this “market making” idea over to decentralised exchanges built on Ethereum is that to make a bid or ask costs gas.

And these gas costs cut into market makers’ profits… so much so that it becomes uneconomical to be a decentralised market maker.

So, what if there was a way to replace these market makers with a smart contract…

One that was always willing to buy/sell at the market rate.

That way, not only would you be cutting out the middlemen (one of the key tenets of crypto)…

But you’d also eliminate the problem of the bid-ask spread altogether.

That’s essentially the idea behind an Automated Market Maker (AMM).

The market making part is simply automated by a smart contract.

Phew!

That was a lot to get our heads around. So we’ll cover how AMMs work in more detail a bit later on.

For now, let’s talk about the benefits.

What are the benefits of AMMs for traders?

From a trader’s point of view, AMMs:

Solve the liquidity problem – they will always offer a fair price on each trade.

Are truly decentralised – they are controlled by a smart contract, not a corporation.

Eliminate gatekeepers – because they’re decentralised anyone can list any asset on them. You don’t need to wait for a “listing”. So there’s no more “wen Binance?” “wen Coinbase?”

And, perhaps most importantly, they are super simple to use. There’s no messing with “limit orders” or depth charts or “bids” or “asks”. 

Users just click on the pair they want to trade, say how much they want to trade, and the interface shows you a price.

For example…