- Decentralized exchanges are still rife with various imperfections including slippage and impermanent loss.
- Chinese crypto project DODO hopes to resolve some of these shortcomings with its novel “Proactive Market Maker” algorithm.
- The platform is nascent, and has yet to prove the test of time like incumbents Uniswap and Curve.
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DODO Exchange, a new arrival to the DEX arena, hopes to grab market share by improving on Uniswap’s imperfections. How?
Through a novel market-making algorithm that improves liquidity and attempts to eliminate impermanent loss.
Getting Started with Decentralized Exchanges
The primary comparison used throughout this guide will be that of Uniswap. Other relevant DEXes include Bancor, Curve, Kyber, and Balancer.
The popular DeFi trading platform offers a base understanding for automated market making (AMMs), the shortfalls of this design, impermanent loss, slippage, and the role of arbitrageurs in a decentralized setting. DODO, and its competitors, is juggling the same constellation of ideas.
AMMs differ from centralized exchanges in the way that they price tokens. Instead of finding a counterparty to buy or sell an asset, and thus establish a price, the counterparty is replaced by a pool of tokens stored on a smart contract. And unlike centralized exchanges, liquidity for these pools is provided by users.
These users are incentivized to provide liquidity by earning returns on the assets they provide. The current trading fee on Uniswap is 0.30%, and this fee is distributed among all liquidity providers (LPs) for helping sustain the platform.
Platforms like Uniswap also differ in the way that they price the assets listed. For the sake of precision, it should be said that there are many types of AMMs. Uniswap leverages a variety called “Constant Product Market Maker.” DODO uses another variety called “Proactive Market Maker.”
Uniswap’s AMM design gets its name from the constant product of its price algorithm. Instead of supply and demand determining the price of an asset like on many orderbook-based exchanges, Uniswap uses the equation x*y=k.
“X” and “Y” represent the supply of a specific token in a pool on Uniswap. As traders buy and sell tokens from this pool (i.e., buy and sell “X” and/or “Y”), the price of each token changes to keep “K” constant.
This design is perhaps the most popular and has helped inspire a range of new ideas in decentralized trading. What’s more, Uniswap has made it easy for anyone to provide liquidity to any ERC-20 token they so choose. There is no listing consortium or gatekeepers that decide which tokens are available to trade.
Unfortunately, such a design doesn’t come without its faults. These include slippage and impermanent loss, to name a few.
Unpacking Current DEX Design Flaws
Slippage refers to the difference between the price an asset is bought or sold, and the price that this sale is executed. In times of high volatility, slippage can be severe due to large swings in price occurring between trades and their execution. In crypto trading, this problem is further exacerbated by slow execution times native to blockchain technology.
Outside of volatility and slow execution times, illiquid markets are also highly prone to slippage. With a large enough trade and an illiquid enough asset, the price of your favorite token could moon or plummet in a near-instant.
On Uniswap, they have managed to minimize slippage for small trades, but large trades can cost traders a pretty penny. The DEX offers traders a variety of tools and settings to better gauge slippage.
Briefly, one can see a tradeoff that Uniswap makes. In exchange for always offering liquidity for illiquid markets, such as obscure tokens, they may keep large whale traders at bay due to excessive slippage on larger trades.
The second, slightly more complicated problem facing Uniswap and a few other DEXes, is that of impermanent loss.
Instead of a third-party oracle, like Chainlink, providing live pricing information, the assets listed on Uniswap are defined internally by the algorithm mentioned above. This algorithm can thus create prices that may be much different than on other platforms.
If the price of LINK rises 15% on centralized exchanges, for instance, this appreciation may not immediately be realized on Uniswap. There is then a period where arbitrageurs can buy LINK on Uniswap for a discounted price, then sell it for 15% more elsewhere.
Arbitration is thus a common occurrence, as traders arrive to either sell expensive or buy cheap assets to turn a profit. This behavior wouldn’t necessarily be an issue, but for LPs on Uniswap. These essential agents on Uniswap can experience severe losses due to arbitrage activity in the form of impermanent loss.
LPs must stake their assets on Uniswap to earn their fees. But during large price swings and active arbitration, the amount of staked assets will change to keep “K” constant.
So, instead of merely holding LINK in your wallet and enjoying a 15% hike in price, you may find that your staked LINK on Uniswap has been arbitraged away.
For a deeper dive into the nature of impermanent loss, readers are advised to read this article.
What Is DODO Exchange?
With the above overview concluded, it’s now time to unpack DODO.
The platform continues to offer on-chain digital asset trading but boasts order execution equitable to centralized trading platforms. LPs and arbitrageurs also play a crucial role in this ecosystem, and the DODO team alleges to have virtually eliminated impermanent loss.
Additionally, though not covered earlier, DODO LPs needn’t supply two sides of a trading pair. To begin earning fees, LPs can add single-asset liquidity to any pool.
It achieves all of these solutions due in part to an alteration to its market-making algorithm, called “Proactive Market Maker” (PMM). Instead of Uniswap’s x*y=k, DODO leverages the following:
The symbol “i” represents the market price of an asset, and “R” refers to the risk factor. Understanding “R” is key to understanding how DODO incentivizes high liquidity at accurate prices.
To establish “i,” DODO will leverage live price feeds from Chainlink, thanks to a partnership made in August 2020. This data creates a baseline, so the DODO algorithm can avoid huge price discrepancies similar to what is sometimes found on Uniswap. And as capital for a particular asset accumulates and becomes more liquid, the “R” function also changes.
The result, according to DODO, is as follows:
“Depending on the liquidity in the capital pool, PMM changes the parameter R in real-time to fine-tune P, the market price on DODO, in order to maximize fund utilization.”
What ends up happening is that liquidity for a particular asset is then shifted to the price of that asset, according to Chainlink data.
Another way to think of the DODO model is to create a real-time market feed as a baseline for prices in the system. Such a model does, however, place a lot of trust in Chainlink data.
If ever Chainlink nodes fail to update correctly or come under attack, DODO could use incorrect price information. This would inevitably lead to significant losses for LPs.
The Team and Investors Behind DODO
Experience is important, especially for DeFi projects building the base infrastructure for an alternative financial system. DODO’s three co-founders are veterans of the blockchain industry.
Mingda Lei is a co-founder at DODO and the architect behind the protocol’s proactive market-making formula. Lei previously served as a core developer at DDEX, a DeFi margin trading platform, and is a Ph.D. dropout from Peking University.
Qi Wang is a software developer and founded DOS Network, a layer two oracle service based in China. Wang worked for companies like Oracle and Pure Storage as a software developer before venturing into crypto.
Diane Dai is the third co-founder. She runs a subscription-based WeChat channel called “DeFi Labs” alongside a myriad of other channels.
Although competition is crowded in the AMM space, DODO recently closed a seed round with participation from notable investors like Framework Ventures, DeFiance Capital, Spencer Noon (DTC Capital), Jason Choi (Spartan Group), Bobby Ong (CoinGecko), and Robert Leshner (Compound).
DODO’s high caliber investors can provide the project with adequate expertise and a network to cement its growth. Framework Ventures, in particular, is known for bringing synergy between its various investments – like Chainlink, Aave, and Synthetix.
Potential Path to Success
Impermanent loss on Uniswap often ends up becoming a permanent loss. And large traders are put off by 50-50 AMMs because of the deep slippage they incur with larger trade sizes. Cumulatively, this is why primitives like DODO are a step in the right direction.
DODO’s use of price oracles rather than purely balancing liquidity around a constant formula enables the AMM to offer traders and LPs better terms. Traders have access to liquidity with better slippage than Uniswap, and LPs only need to deposit one token, potentially mitigating impermanent loss woes.
One concern is that without adequate trading volumes, LPs can still face a loss on DODO. If traders utilize liquidity but total fees earned by LPs is low, the net result is a loss. For LPs to make steady profits from market-making on DODO, volume needs to increase consistently.
Currently, the protocol is in a nascent stage, so volume is perhaps less of a concern than ensuring the product works well. If everything runs smoothly, DODO can give other AMMs a serious run for their money.
Automated liquidity provision coupled with the pricing and liquidity of an orderbook could turn out to be an effective combo and the best iteration of AMMs.
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