Chapter 1 - Introduction to GammaSwap
Introduction to Automated Market Makers (AMMs)
To provide liquidity for new coins, a new approach had to be implemented for the blockchain given the limitation of order books (CLOBs) on high latency blockchains like Ethereum.
In Traditional Finance, a central limit oder book (CLOB) is an order book and matching engine utilized by equity markets to support liquidity for bids and asks. It is a transparent system that matches customer orders (e.g. bids and offers).
To create deep liquidity, a few centralized market makers use high frequency methods to send and cancel thousands of orders every second. It requires extremely low or no fees to operate successfuly. In a higher fee environment like Ethereum L1, this approach has proved not to be economically viable. This is why AMMs are a popular way to faciliate trades in DeFi. Popularized by protocols like Uniswap, Curve and Balancer, the AMM model succeeded where order books couldn't on Ethereum. AMMs like Uniswap V2 can pool assets together and price them by the ratio of supplied tokens maintaining the liquidity invariant, x*y=k.
AMMs do not require any centralized market makers to actively manage liquidity. Instead, AMMs can leverage the benefits of decentralized networks by democratizing market making. Liquidity providers can deposit tokens into pools to earn passive yields replicating ETF like products.
AMMs seem to be a perfect solution given the constraints of blockchain technology, however, current AMM implementations pose significant challenges.
Problems with AMMs
There are a few problems with AMMs currently.
Liquidity Providers take on "volatility" risk but are paid in volume
Traditionally, liquidity providers take on IL risk but are paid in swap fees from volume. Volatility may be correlated with volume but they are not equal. Research show that volume from swap fees often do not compensate retail LPs adequately for their risk. This is an inefficiency hindering the growth of DeFi.
There is no way to buy "insurance" (hedge) an LP position
Daniel Alcarraz, co-founder and inventor of the GammaSwap protocol, models Uniswap LPs as option sellers given the dynamic rebalancing of the pool as the prices of the tokens move.
Liquidity providers sell volatility but there is no way to get the "opposite" exposure, to buy volatility from the AMM. GammaSwap enables you to borrow liquidity which profits when there is volatility or Impermannet Loss. This could be used to hedge Impermanent Loss, delta exposure or act as "rug" insurance for new projects.
GammaSwap Fixes AMMs
GammaSwap fixes the issues with AMMs by compensating LPs in the actual unit of risk they are taking, volatility. Borrowers short Impermanent Loss to profit off Impermanent Gain. Their debt is denominated in the liquidity invariant of the AMM, the classic x*y=k formula. If volatility is high and liquidity providers have higher IL risk, borrowers are incentivized to come in and borrow more liquidity since it is profitable for them to do so. This means the liquidity is now dynamic based on market volatility.
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