In this interview, we explore the evolving landscape of decentralized exchanges (DEXs), particularly focusing on the market leader, Uniswap. We discuss the significance of using mathematical functions for price determination in exchanges, which diverges from traditional order book systems. The conversation highlights the advantages of the Constant Product Market Maker (CPMM) model and emphasizes the role of smart contracts in its proliferation within the decentralized finance (DeFi) ecosystem. Notably, we introduce the concept of impermanent gain, which provides new perspectives on impermanent loss under certain conditions for liquidity providers. Additionally, we address the crucial role of user education and the practical implications of research findings on established DeFi platforms like Uniswap. We also cover the regulatory challenges facing DEX and the importance of implementing measures to enhance trust between users and platforms. Ultimately, this interview offers realistic insights into the future of Automated Market Makers (AMMs) and the prospects for businesses like Uniswap to enhance profitability through innovation alongside the ongoing research needed to navigate the complexities of digital finance.-- Ed.

 

Q&A with Professor Hyoung Joong Kim (khj-@korea.ac.kr) from the Business Group for the Next Generation of Communication at Kookmin University.

 

Q: Price Determination: Can you explain the importance of using mathematical functions for price determination and how this differs from traditional order book systems in decentralized exchanges?

A: Historically, it seems there has never been a case where prices were determined by a mathematical formula. The process of discovering prices has been bypassed, yet it feels surprisingly natural to accept a determined price, similar to buying items at a fixed price. The mathematical price determination was first attempted by Uniswap in 2018, and it has since taken root in the market, making the company a unicorn. This method has been adopted by several decentralized exchanges such as Sushiswap and PancakeSwap. Recently, mathematical pricing has also been applied in prediction markets.

Q: Constant Product Market Maker: What are the key advantages of using the Constant Product Market Maker (CPMM) in decentralized exchanges, and why do you think it has been widely adopted?

A: Understanding the meaning of constant product is crucial. The constant product refers to keeping the product of the quantity of coin A and the quantity of coin B constant. As the quantity of coin A increases, the quantity of coin B must decrease so that the product is a constant, and vice versa. If the quantity of coin A decreases while that of coin B increases, it indicates that the value of coin A has been relatively higher compared to coin B. In other words, a smaller quantity corresponds to a higher price and a larger quantity to a lower price, a universal truth utilized in price determination. People perceive this method as fair, and it functions through smart contracts, which is significant, suggesting that this approach has the potential for wide use in the future.

Q: Causes of Impermanent Loss: What causes impermanent loss?

A: It is widely acknowledged that liquidity providers suffer a loss on exchanges utilizing CPMM. This loss is referred to as impermanent loss and has been accepted as a norm because it has mathematically been proven that loss always occurs. The prices used in this context are represented by the ratio of the quantity of coin A to that of coin B, which is the fundamental cause surrounding impermanent loss.

Q: Types of Mathematical Pricing: Are there multiple types of mathematical pricing?

A: In the effort to eliminate impermanent loss, I found that at least two types of mathematical pricing exist. The price of coin A is represented by the ratio of the quantity of coin A to that of coin B, which is referred to as the relative price. However, using this pricing does not allow for the removal of impermanent loss, and this relative price is, in fact, not the exact price of coin A.

The actual price of coin A is expressed as the absolute value of the ratio of the increment in the quantity of coin A to that of coin B. I refer to this as the actual price, which is not the exact price either. The relative price is the price before a transaction takes place, the actual price is the price at the moment the actual transaction takes place, and the difference between the two prices is called slippage.

Q: Impermanent Loss and Gain: The paper suggests that impermanent gain can be achieved under certain conditions. What are these conditions, and how do they benefit liquidity providers?

A: Completely eliminating impermanent loss is impossible. However, contrary to prior knowledge, I discovered that gain can occasionally occur. For gain to be realized, two conditions must be satisfied. First, the use of the price, not the relative price. For example, in the past, when liquidity providers first participated in the liquidity pool, they deposited 10 coins, and after many transactions, there are now 11 coins, and at some point in the future, when a trader wants to buy two coins, the quantity of coins will decrease to 9. In other words, the second condition is that it goes from 11 to 9 (with 10 in the middle). The second condition is not always satisfied, so gain arises only when both conditions are met simultaneously.
Though the second condition is not always met, it can be satisfied on occasion. Therefore, the foundational belief that overcoming impermanent loss is impossible needs to be revised. I stumbled upon this fact serendipitously.
The possibility of generating gain is good news for liquidity providers. Previously, they had incurred loss by depositing coins into the liquidity pool. There is no guarantee that you will always profit, but it does give you hope. This discovery is very helpful for AMMs based on CPMM.

Q: Mathematical Proof: Can you explain the mathematical proof showing the possibility of impermanent gain in the CPMM model?

 A: I have proven that profits can be made, and detailed information can be found in my paper. The content of the paper is straightforward, so anyone can easily understand it. The key points lie in the two conditions I previously explained.

Q: The Acceptability of the Impermanent Gain Theory: Is the impermanent gain theory acceptable?

A: The price of Ethereum on a decentralized exchange is sometimes the same as the price of Ethereum on a centralized exchange, but most of the time, they are different. Referring to the price on a decentralized exchange can result in an impermanent loss, but referring to the price on a centralized exchange can result in an impermanent gain. You can choose between the relative and prices on a decentralized exchange.

Q: Practical Implications: How do you envision the practical implications of your findings for liquidity providers in existing decentralized finance (DeFi) platforms?

A: My theory is practical in AMMs. In the DeFi space, AMMs represent only a portion of the broader landscape. The most important contributors within AMMs are the liquidity providers, and it is essential to ensure that they do not incur losses. Uniswap has not been able to make a profit in trading because it has failed to find ways to avoid incurring losses for these critical contributors. If it had been calculated at a price rather than a relative price, most of the time, there would be a loss, but there would be a very low probability of a gain, so the term impermanent loss would not have been created at all.

Q: Future Developments: What future advancements or improvements would you like to see in the AMM sector to make it more efficient and profitable for users?

A: I am currently developing a minimum viable solution (MVP) operating on the Solana blockchain with a grant supported by Composable Finance. Anyone who tries out the MVP will be able to understand my theory. Meanwhile, the market is experiencing transaction ordering manipulation known as maximal extractable value (MEV). MEV, which maximizes the profits of block producers, may result in loss for traders. I am implementing methods to utilize MEV in a way that benefits liquidity providers and traders.

Q: Concentrated Liquidity: What discussions does your paper have about the concentrated liquidity of Uniswap V3, and how does this innovation improve or challenge the traditional CPMM model?

A: Compared to V1, V3 has made significant advances; however, it has not resolved the issue of impermanent loss and may have even exacerbated it. Nevertheless, V3 is overwhelmingly preferred as it applies CPMM on a range-by-range basis rather than covering the entire range as a single CPMM like V1. I am also exploring methods to generate profits with V3.

Q: Motivation for Research: What motivated you to explore the topic of impermanent loss and gain, and how do you think this research will impact the field of digital finance?

A: Initially, my academic curiosity led me to approach impermanent loss, and through several trials and errors, I gained a better understanding of it. I eventually realized that it was possible to achieve impermanent gain and mathematically proved it.
The field of digital finance is broad and new, with many areas still to be developed. I have merely touched on a small issue regarding AMMs. Moving forward, many others should tackle numerous challenges, and collaborative effort is essential. I would like to share information and collaborate with good researchers.

Q: Broader Impact of DEX: How do you view the impact of DEX on the overall cryptocurrency market and user trust compared to CEX?

A: DEX may struggle to exist if subjected to strict regulation by financial authorities, as they do not account for KYC and AML. Although DEX cannot operate like CEX, it is necessary to take measures to secure trust from customers and regulatory authorities. Without such measures, regulators could prohibit coin movements between CEX and DEX, leading to the contraction of DEX. However, DEX is highly useful for developing genuine decentralized finance solutions utilizing smart contracts while ensuring some level of anonymity.

Q: Regulatory Considerations: What regulatory challenges do you foresee as a result of the rise of DeFi, and how might this impact the development and adoption of projects like CPMM?

A: Regulatory authorities are primarily focused on customer protection and anti-money laundering measures. In the long term, researchers involved in AMM should also take an interest in strategies to address these two issues.

Q: User Education: How important is user education in understanding the mechanisms of impermanent loss and gain, and what measures should be taken to better educate liquidity providers?

A: Many people are already well aware of impermanent loss, and they are unaware of the possibility of impermanent gain. With the publication of my paper, I anticipate receiving a lot of feedback, both positive and negative.

Q: Practical Case Studies: Can you share any successful applications or case studies where your findings have been successfully implemented in DEXs or liquidity pools?

A: I hope to see increased activity in research within this field, and I remain open to collaborative research and partnerships. Currently, I am developing an MVP with support from Composable Finance, so a prototype should be presented in the first half of this year. I expect that the publication of my paper will lead to substantial feedback, and I anticipate that several companies will adopt or improve upon this technology.

Q: Advancements in AMM: How do you foresee AMMs developing in the coming years, especially considering rapid technological advancements and changing market dynamics?

A: I believe that AMMs will continue to evolve in various directions. This evolution will include efforts to reduce impermanent loss. Additionally, AMMs are already being utilized in prediction markets. While impermanent loss does not occur in prediction markets, it might lead to a shift towards using pricing rather than relative prices when determining coin values.

Here is Professor Hyoung Joong Kim's Paper: "What Must the Price in Decentralized Exchanges Be?"