Information is crucial in financial markets, and professional traders or institutions will spend millions just to be located closer to the stock exchange and have access to the most stable and fast optical internet cable. The tiny edge of receiving information a split second earlier than competing firms can make the difference.
Recently the 1inch team made an excellent analysis on this topic and concluded that in today’s volatile DeFi markets arbitrageurs make a lot of returns on liquidity providers on AMMs. In volatile markets, informed market makers will always outperform uninformed market makers because there is less opportunity for arbitrageurs.
In mature financial markets, informed market makers outnumber uninformed market makers simply because they are more profitable by adjusting their trades based on relevant information. While some information is straightforward (eg. significant price changes on other markets), some types of information need to be interpreted. The interpretation of information by informed market makers is done subjectively, based on their market opinions and appetite for risk.
In traditional finance, we see a diverse landscape of market makers, hedge funds, and algo-trading companies that all adopt trading strategies like bullish, bearish, long volatility, short volatility, focussed on tail risks, etc. Based on the risk they take and the quality of their information sources, market makers would make varying returns on their capital and would compete with one another on order books of various exchanges. This organic competition between participants is what makes a market efficient and liquid, and there is nothing wrong with this dynamic.
There are many ways to Rome; there are many ways to increase your returns by accepting different risks.
With AMMs in DeFi today, we don’t have a diverse set of market participants with varying strategies. Instead, we have one (automated) player that deploys capital of its liquidity providers. Liquidity providers earn high returns on their capital today due to limited competition and liquidity mining rewards, but once more advanced players start deploying their trading strategies in DeFi markets we will see them vastly outperforming liquidity providers of uninformed AMMs. Another interesting phenomenon to observe is the rise of a new generation of AMMs that implement a basic trading strategy in their pricing algorithm. An excellent example is Mooniswap, launched by the 1inch team, which should outperform Uniswap in high volatility markets.
So far we have learned that DeFi today has too little diversity in supply-side liquidity, and market makers could find better returns by adopting informed trading strategies. Once the market matures, we will see more diversity in market makers that will compete for alpha. Where will these market participants meet one another?
We need a place for these players to be arranged for traders to trade against. Although DeFi birthed a lot of interesting new concepts, such as AMM-DEX aggregators, we don’t expect order books to be replaced in the long term. It’s an effective tool for arranging market participants and DeFi should not reinvent the wheel here.