The problem of capital efficiency in Swap

Key points

  1. The DeFi agreement generally has the problem of low capital utilization efficiency, which is mainly manifested in the underutilization of liquidity in the Swap field. Swap mainly adopts the AMM (Automatic Market Making) model. Since AMM distributes funds evenly over the entire price range (0, +∞), only funds allocated near the market price can be used effectively.
  2. In view of the limitations of AMM, a large number of Swap agreements have launched innovations to improve capital efficiency. Among them, there are three particularly eye-catching innovations: centralized liquidity, improvement of the AMM curve, and reinvestment using DeFi’s composability. Some agreements may make trade-offs in two or three directions at the same time.
  3. Centralized liquidity guides liquidity providers to deploy funds in the most frequently traded interval to obtain higher handling fees and effectively control risk exposure; improved AMM curves (even customized) give liquidity providers more Large flexibility and autonomy can help provide liquidity for specific use cases and specific goals, and the improvement of the curve can also point to centralized liquidity; DeFi’s composability allows liquidity providers to reinvest and obtain Higher return on funds than handling fees.
  4. UniswapV3, which will be launched soon, is committed to achieving “centralized liquidity”; DODO and Kyber DMM are mainly based on customized AMM curve logic and are guided in the direction of centralized liquidity; Curve is the first swap to utilize DeFi composability, and BannerV2 introduces The asset manager has a whole new idea. No matter which method is adopted, new market opportunities will eventually be derived.
  5. Fundamentally speaking, the performance bottleneck of Ethereum is the “hidden asymptote” of many Swap protocols to improve capital efficiency. This is also the fundamental reason why Polkadot and Binance Smart Chain can snatch a large number of protocols and users. It explains why various Layer 2 The scheme and cross-chain liquidity agreement have set off a huge investment boom this year.


On March 23, Uniswap officially released its V3 version of its automatic market maker (AMM) program. The core content includes centralized liquidity, multi-level rates, range orders, advanced oracles, copyright protection, etc. The program will be in May Officially launched on the 5th.

Among them, the introduction of concentrated liquidity has triggered a lot of discussion. This feature enables liquidity providers (LP) to finely control the scope of capital distribution, so that capital efficiency is theoretically improved by up to 4000 times compared with Uniswap V2, paving the way for low slippage. It can be said that the core of Uniswap V3 is to improve capital efficiency.


Picture description: As the largest Swap leader on the Ethereum chain, Uniswap’s capital efficiency is very low. Although the amount of locked positions is constantly rising to nearly tens of billions of dollars, the highest transaction volume in history is less than 2.5 billion dollars. On April 25, the fund utilization rate on Uniswap was only about 8.4%.

In fact, it is not just Uniswap. In the entire DeFi field, a large number of projects and agreements are competing for improving capital efficiency. Some people have done rough statistics. Most of the incremental DeFi market in 2021 will come from projects that can effectively improve capital efficiency.

Why is capital efficiency important?

Traditionally, capital efficiency is used to describe the ratio of a company’s expenditure on increasing revenue to the return it receives, also known as the “return on capital” (ROCE). This means that the higher the capital efficiency, the greater the opportunity for investors to make a profit; and the lower capital efficiency means lower profit opportunities, higher liquidity discounts, and risk discounts.

As Bloomberg columnist Matt Levine said, the crypto world is replaying the history of modern finance, but only in an alternative and accelerated timeline. This means that the pursuit of capital efficiency will eventually become a necessity for the DeFi agreement.

Specific to the Swap field, the competitive result of capital efficiency between different agreements will be that liquidity providers will switch to the highly capital-efficient Swap agreement, triggering agreements with lower capital efficiency to enter the spiral of reduced lock-up and liquidity — -Last September, the “vampire attack” launched by Sushiswap against Uniswap is a classic case.

On the surface, the liquidity mining mechanism of Sushiswap issuing SUSHI tokens and repurchasing dividends has created incentives for liquidity providers, but it is basically because the liquidity providers receive higher returns. Therefore, it is not surprising that it robbed a large number of Uniswap positions in a short period of time. In the future, in the DeFi field, due to different capital efficiencies, a high degree of competition between agreements and even cross-chain competition will be the norm.

What causes capital inefficiency?

AMM curve limit. The AMM automatic market maker mechanism is the core of the Swap protocol, which is mainly promoted by Uniswap. Swaps such as Curve, Balancer, and DODO are all improved on the basis of inheriting the core design of Uniswap.

Since AMM distributes funds evenly over the entire price range (0, +∞), only funds allocated near the market price can be used effectively. Take Uniswap V2 as an example, all liquidity is provided according to the constant product curve of “X * Y = K”, from 0 to infinity. In addition, the imbalance of the liquidity pool composed of the two tokens can only be achieved by relying on the “arbitrage” of external exchanges-when the market fluctuates and prices change, AMM will not immediately adjust the price, but wait for arbitrage transactions. , This will change the liquidity provider’s investment portfolio and cause huge losses.

But in fact, “X * Y = K” is not static. A slight improvement of the function and modification of the slope of the curve can lead to different results and a great improvement in capital efficiency. This is the basic strategy adopted by many Swap protocols when making improvements.

Ethereum performance. Most DeFi projects are built on the Ethereum blockchain. The performance of Ethereum (low transaction throughput, 15-second block time delay, etc.) constitutes the basis for the inefficient capital efficiency of DeFi protocols including Swap protocols. the reason. For example, increasing the leverage of funds will greatly improve capital efficiency. In the current environment of Ethereum, considering the volatility of crypto assets and the 15-second block time delay, highly leveraged products have become difficult to realize.

However, the richness of the Ethereum ecosystem provides a basis for the composability between protocols, and the “DeFi doll” effect brought by composability can objectively increase the return on capital.

In summary, for Swap, the most basic ways to improve capital efficiency are:

  1. Moving to centralized liquidity: Uniswap
  2. Improve AMM curve: DODO, KyberDMM, Perpetual Protocol
  3. Utilize the composability of DeFi: Curve, Balancer, Deriswap

In addition to the above methods, in order to break through the bottleneck of Ethereum and improve capital efficiency, many projects are considering combining Layer2; however, the current more popular trend is to establish projects on Polkadot and BSC. DODO has been deployed on BSC, and Pancake on BSC has surpassed Uniswap to become the largest Swap protocol in the DeFi field.

Case: How does SWAP improve capital efficiency?

Uniswap V3

The Uniswap official blog announced the V3 vision on March 23, with the core focus on improving capital efficiency.

Centralized liquidity is the most significant design of V3 to improve capital efficiency. It gives liquidity providers “granular control” and allows each liquidity provider to set a price range for the liquidity it provides, so that assets can be allocated in the price range with the highest transaction frequency, instead of evenly placing assets Every point on “X * Y = K”. Those who are concerned about transactions should know that the price near the market price generates the most orders and brings more handling fees; the further away from the market price, the less likely it is to complete the transaction, and the handling fee cannot be obtained.

At the same time, centralized liquidity will also allow liquidity providers to control the proportion of free losses they can accept with the help of price range control.

Ultimately, centralized liquidity is achieved by combining all positions in the liquidity pool to create an aggregation curve for traders, which can theoretically increase capital efficiency by up to 4000 times.

In addition, the introduction of multi-level rates and advanced oracles will also improve capital efficiency to varying degrees. The former has changed the fixed 0.3% fee rate of V2 and introduced multiple fee levels, namely 0.05%, 0.3% and 1%. Liquidity providers can use their own risk appetites in high-risk unrelated token pairs. Choose between and related token pairs to improve capital efficiency; the latter improves the performance of the time-weighted average price (TWAP) price input mechanism, making price query faster and lower cost.


Trying to build a new AMM to improve capital efficiency by imitating market makers in a centralized market to bring sufficient on-chain liquidity. The market in the centralized market will always buy and sell near the market price, and withdraw liquidity when the market encounters huge risks. This idea is actually the earliest “centralized liquidity” idea in the Swap protocol. In a sense, Uniswap V3’s centralized liquidity is also a follower. However, there are essential differences between the two in terms of specific implementation.

Specifically, DODO improved Uniswap’s constant product function, introduced the active market maker (PMM) algorithm, introduced external oracles (Chainlink) quotations, aggregated the maximum liquidity near the market price, and then smoothly reduced the slope of the curve to the left and right ( The reduced slope amplitude can be freely adjusted by setting parameters). Due to the relatively flat curve of PMM, liquidity providers will be able to benefit from lower slippage.

In addition, in the AMM defined by Uniswap V2, when the market fluctuates and the price changes, AMM will not adjust the price immediately, but will realize the price adjustment through arbitrage trading. Therefore, the price has a certain lag and cannot resist the risk attack. . The real-time price can be obtained by introducing an external oracle quotation, and PMM will adjust the price curve according to the real-time price to ensure that there is still sufficient liquidity. In this way, it is ensured that the capital utilization rate can be maintained at a high level.

Another key change brought about by the PMM algorithm curve is that it allows unilateral market making. The DODO liquidity provider does not need to provide the two assets of the trading pair. In order to earn fees, liquidity providers can add the liquidity of a single asset to any pool of funds. This will also greatly release the potential of assets and improve capital efficiency. At the same time, it will also reduce the risk exposure faced by liquidity providers.

Kyber DMM

The Beta version of the Kyber DMM (Dynamic Market Maker) protocol has been launched on April 15th. This is a new liquidity protocol for retail liquidity providers and token teams, and will be circulated in Kyber3.0 Sex Center is the first to go online. In terms of improving capital efficiency, the most critical aspect of Kyber DMM is the introduction of liquidity pool capital amplification factor (AMP) and dynamic fees based on market conditions.

The setting of AMP is achieved through Kyber DMM’s programmable pricing curve. The creator of the liquidity pool can customize the pricing curve, and can set the AMP of the liquidity pool in advance, and the liquidity provider can choose the pool that wants to inject liquidity based on the AMP.

In a specific price range, the higher the AMP, the higher the capital efficiency: when AMP = 1, the pool does not contain any enlargement marks, and the liquidity is distributed on (0, +∞); the larger the AMP, the automatic market-making curve The more gradual, but the effective/tradable price range will also shrink-this brings another way to achieve centralized liquidity. Stable currency pairs with low price volatility (such as USDT/USDC) will be able to support liquidity pools with high amplification factors.

In addition, Kyber DMM will monitor the transaction volume on the chain and adjust the price accordingly, and dynamically determine the rate that the liquidity provider can obtain based on price changes. When the market is in a normal state, DMM will operate like a basic AMM; when the transaction volume is higher than usual, DMM will increase the fee; when the transaction volume is lower than usual, DMM will reduce the fee. This dynamic process breaks through the limitation of Uniswap V2’s constant 0.3% transaction fee, and can maximize the income of transaction fees for liquidity providers.

Perpetual Protocol Perpetual Protocol is one of the few decentralized derivative protocols that adopt the AMM mechanism. Considering the huge volatility of crypto assets and the 15-second block delay of Ethereum, the provision of decentralized derivatives services with high leverage will face great risks.

However, Perpetual creatively introduced a virtualized automated market maker (vAMM), which made it possible for investors to increase capital efficiency by increasing leverage. The important thing is that vAMM is a price discovery mechanism rather than a spot trading mechanism and does not require a liquidity provider. Its working mode is like this:

  1. Before trading with vAMM, traders need to deposit their collateral in a vault, which is the same step as other derivatives exchanges (initially only USDC is supported, and other collaterals may be introduced later).
  2. After depositing the collateral, they can trade perpetual contracts just like on a centralized exchange. The difference is: in a centralized exchange, the counterparty of the trader is the pending order party of the centralized limit order book (CLOB) , And the counterparty of Perpetual traders is vAMM itself.
  3. Perpetual’s vAMM uses the same xy = k curve as Uniswap. Since vAMM is virtualized, the value of k is also virtual-which means that it can be adjusted algorithmically based on transaction volume, open interest rates, financing rates, and other market data. As the value of k increases, traders have lower slippage.


The service provided by Curve is currently mainly the swap between stablecoin protocols and the swap between BTC-linked tokens (such as sBTC, RenBTC and WBTC). This special use scenario makes it possible for Curve to improve capital efficiency by customizing the AMM curve and changing the slope of the curve. However, its biggest inspiration lies in the Swap protocol that uses DeFi’s composability to improve capital efficiency.


Picture description: Curve’s famous Stable Swap curve (blue line in the middle).

A typical Curve liquidity provider, his income may come from: the interest income obtained by depositing Dai in a loan agreement such as Compound or AAVE; the generated cDai enters the Curve liquidity pool to obtain transaction fee income and Curve liquidity mining Mine rewards. But this may be the simplest case.

Curve has a large number of complex pools. Taking the sBTC pool as an example, the liquidity provider provides liquidity in any currency, and it will be deposited in the liquidity pool according to the proportion of renBTC, wBTC, sBTC, 45%, 35%, and 20%. Ultimately, the rewards that liquidity providers can obtain in addition to handling fees include not only CRV, but also the rewards SNX and REN provided by sBTC and renBTC. If the SNX and REN project parties deposit reward tokens in the Balancer pool, the liquidity provider will also receive BAL rewards.

Balancer V2 The core principles of Balancer V2 are security, flexibility, capital efficiency and gas efficiency. In terms of capital efficiency, the biggest innovation of Balancer V2 is the introduction of Protocol Vault and Asset Manager. In V1, different pools are equivalent to different vaults. The function of the agreement vault asset manager, liquidity providers can use the agreement vault to hold and manage all the assets of the Balancer fund pool.

The agreement vault can lend tokens to the loan agreement to increase the income of the fund pool, thereby improving capital efficiency. However, the vault will ensure that the needs of the buffer mechanism are met, otherwise the transaction will fail.

In addition, another advantage of the protocol vault is that even if users perform batch transactions involving different fund pools, only the final net token amount will be transferred in or out from the vault, which in turn prepares for low gas fees and arbitrage transactions Necessary conditions.


Picture description: The agreement vault controls the assets in the pool and exerts asset management functions. Idle assets can be deposited into other agreements (such as loan agreements) to get more income.

The key arrangement to achieve the above functions is that Balancer v2 separates the automatic market maker logic from the token management and accounting. Token management/accounting is done by the agreement vault, and the automatic market maker logic differs depending on the fund pool. Since the fund pool is independent of the agreement vault, the two are controlled by different smart contracts, and customized automatic market maker logic can be realized.

Ethereum’s invisible asymptotes

Whether it is Uniswap, or DODO, Curve, Balancer, the above cases have proved that it is feasible to improve capital efficiency within the Ethereum system. Either way, it may bring some new opportunities, such as “centralized liquidity” is likely to lead to the emergence of specialized liquidity market making. We are likely to see such professional institutions and strategic service providers.

However, Ethereum performance will be the “invisible asymptote” of these Swap protocols. In a working paper by Multicoin Capital, the invisible asymptotes are used to compare those invisible upper limits. It cannot be directly measured and can only be shown in counterfactual analysis, but it limits growth. The implicit asymptote of Ethereum includes both its transaction throughput and 15-second block delay. If these problems cannot be solved, the project will eventually face a ceiling of growth. This is the prerequisite for many high-performance public chains (smart contract platforms) to fully enjoy the spillover effect of Ethereum.

In this bull market, Polkadot, Cardno, BSC, Solana, Near and even hecochain are all building an ecosystem parallel to Ethereum, and many have achieved great success. The competition and cooperation between different ecosystems will again bring about the dispersion of liquidity, so cross-chain liquidity will also be our next research topic.

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