Elixir: A Decentralized Liquidity Engine

Crypto market making is a critical service for the industry that can help reduce token volatility and provide traders with optimal execution prices. Market making also represents a significant operating expense for many protocols, as liquidity is essential for most governance tokens. A market participant will have no desire to purchase a token if a $500 purchase moves the price 10%. When a protocol hires a market maker, the protocol usually pays a fee or even its own token to a market maker in exchange for services.

Elixir Protocol is an upcoming protocol that seeks to siphon market share from centralized market makers, such as Wintermute and GSR, via competitive pricing and incentive alignment. Instead of concentrating market making power in the hands of a small selection of centralized market makers, Elixir seeks to offer a transparent solution where protocols can hire market making services and distribute tokens into the hands of less predatory participants. Elixir would allow anybody, regardless of their ability to code algorithms and manage liquidity bands, to benefit from market making fees.

Market Making Today

As mentioned above, crypto market making can be expensive, and often results in a protocol funneling its own tokens at a discount to a centralized party who likely does not have the best interests of the protocol in mind. Market makers usually require a loan of native tokens so that they can both buy and sell an asset around its market price. This loan is then matched with stablecoins to begin market making operations. Market makers often have several KPIs to focus on and achieve these through setting bid-ask spreads, trade frequency, and order book depth. When market making, firms must identify the best bid-ask spread to preserve inventory, maximize profitability, and ideally remain market neutral.

Market making firms stand to profit from an order book spread, as well as arbitrage opportunities. For example, if the bid for a token is $50 and the ask price is $55, the market maker can pocket this spread of $5 upon completion of the trade. In exchange for services, market makers sometimes receive a call option to buy a significant portion of token supply at a set price upon conclusion of a market making engagement. This provides an incentive for the market maker to run the token price up to protect its interest in its call option, removing ideal market neutrality from market making. Stargate currently has a proposal on its forum that offers a great inside look into the world of crypto market making. Another example can be found on the Index Coop governance forum.

Remember that the very reason Uniswap marked such a significant leap forward for liquid token markets is that it enabled anybody to provide 50/50 buy/sell liquidity with the click of a button, removing the need for centralized market makers. Providing liquidity in a 50/50 weighting exposes users to undesirable impermanent loss, and LP token rewards often do not justify impermanent loss exposure. Further, a simple deposit into a x*y=k pool does not provide optimum capital efficiency, leaving both liquidity providers and protocols with subpar results. From a quick glance at how liquidity mining incentives worked out in the long run, go look at Ribbon Finance’s RBN token, which currently has $1M in its liquidity pool. Now look at its market cap of $160M. This ratio is not ideal. Both CEX and DEX market making liquidity incentives results in the same outcome: inflationary token emissions for unsustainable liquidity.

A huge barrier to entry for DeFi is liquidity. A DeFi protocol often struggles to gain adoption outside of the DeFi bubble because of low AUM, which cannot be gained without ample liquidity in both governance tokens (for protocol participation) and lending/trading markets. Even for TradFi institutions to enter the DeFi space with size, the current market making landscape needs to expand multiples larger. For trustless and decentralized solutions to succeed, they first need to become competitive with centralized market making solutions.