The yield farming revolution has been one of the biggest stories in DeFi over the last year, thanks largely to automated market makers (AMM). Operating behind the scenes, these protocols attracted billions of dollars into smart contracts. Spurred by incentives in the form of newly minted tokens, investors dove into AMM’s liquidity pools and changed the DeFi landscape.
Yet while the trading volume of AMMs almost put them on par with centralized crypto exchanges, they have an inherent flaw: They have to be kept alive artificially like the walking dead.
To navigate fit the bottleneck of blockchain throughput, AMMs reduce the market making mechanism for crypto assets to two liquidity pools and an exchange rate that naturally adjusts based on relative demand. This primitive model is similar to a merchant in an ancient marketplace, swapping grain and beans between two piles on request.
While this model is elegant in its simplicity, it doesn’t look after the liquidity providers and traders that make the ecosystem sustainable in the long run. AMMs currently face several inefficiencies, including:
- Traders pay high gas fees and often suffer slippage and partial fills of their orders. Low levels of liquidity are split between multiple incompatible blockchains and protocols, meaning big traders experience very poor execution.
- Liquidity providers suffer impermanent loss, which is a misnomer as unless the price of deposited tokens correct after bouts of volatility, then the loss will be permanent. This is because the liquidity providers are forced to passively sell tokens with rising exchange rates, and buy tokens with falling rates. So unlike active market makers on order book exchanges that can adjust their strategy, they end up paying to provide liquidity instead of making money.
- The biggest beneficiary then, is not community members such as traders or liquidity providers, but arbitrageurs that can flit between exchanges and snipe cheap assets until the AMM pools are correctly priced.
Despite the best efforts of developers to patch these problems and make AMMs more user-focused, impermanent loss is a feature, not a bug. As such, it cannot be completely eliminated.
The only way to counteract the losses of liquidity providers on AMMS is by constantly printing new tokens as rewards (token printer goes “brrrr!”). Ironically enough, that resembles central bank policy.
Like a financial zombie, AMMs can remain active for a time by feeding on the stream of new token buyers. But when the speculative fervor subsides and new buyers disappear, selling pressure pulls token prices down Liquidity providers, noticing falling yields, then simply move on to freshly launched protocols and the cycle continues.
Amid this endless search for yield, the AMM model is being threatened by two intrinsic blockchain limitations: lack of interoperability and scalability.
Yield-earning activity spurred by token incentives is pushing underlying blockchains to their limits. Thus high fees and delayed transactions are pushing liquidity providers towards AMMs operating on new sidechains, Layer 2s and Layer 1s. But lack of interoperability means most new chains are incompatible, so moving funds between them means incurring additional fees and often using a centralized bridge that threatens the integrity of the whole system.
In this rapidly dawning multichain future, a new contender for accruing value and delivering yield is emerging.
Middleware—a term borrowed from networking that refers to software acting as a bridge between applications—has a big opportunity to become the first port of call for liquidity.
The Rise of Middleware
In the blockchain world, middleware can interact with different chains to scope out multiple liquidity sources—whether from AMM pools, central limit order book (CLOB) DEXes, or even off-chain sources. To the end user, the underlying protocols providing the liquidity are simply abstracted away through a single user interface, much like cryptographic standards like https are invisible to the end user.
The benefit of this abstraction is already beginning to be reflected in the growing popularity of two types of emerging middleware: First, the initial wave of DeFi aggregators serving individual traders, and second, the all-in-one custody and settlement platforms that are rapidly becoming the preferred portal for institutions to access digital assets.
Retail-focused DeFi dashboard InstaDapp, for instance, has become the second-largest dApp by Total Value Locked, sitting behind only lending giant Aave. Other aggregators including Zapper and Zerion have seen similar levels of success, attracting high volumes of users without needing the inbuilt incentives offered by AMMs.
On the institutional side, the appetite for middleware platforms is equally strong. Immense amounts of value are flowing through institution-focused wallets like Fireblocks, which has now handled more than $500B in digital assets. While this is ostensibly a custodian, a large part of the value proposition comes from being able to compare rates from a single interface and easily access fragmented liquidity across different exchange platforms and DeFi protocols.
A new liquidity battleground
The strong growth of emerging middleware platforms suggests they are here to stay. But as of yet, they are missing the opportunity to deliver a critical blow to AMMs by capturing value and returning it to the community through crypto economic incentives.
As SushiSwap’s Vampire Attack showed, tokenomics can provide a powerful way of aligning individual incentives with network objectives to spark explosive growth. This may be impossible for centralized institutional custodians, but it offers a big opportunity for protocols that stay true to the principles of open and permissionless finance.
Without any of the intrinsic limitations of AMMs, this new generation of middleware protocols are well-positioned to offer more sustainable incentives that move beyond utility, security, and governance to incentivize all users and generate real long-term network value.
With such incentives in place, we might see a trend that echoes Web 2.0: Value will not be accrued to the underlying ‘protocol layer’— as with https or today’s AMM protocols — but to the layer of abstraction above in the form of community-driven middleware.
Anthony Foy is the CEO of cross-chain liquidity protocol Qredo.
Kieran Smith is a London-based writer and cryptocurrency analyst.