I’ve been thinking a lot lately on the DEX situation on the IC and other networks. This is a concise compilation of those thoughts to discuss, if someone finds it interesting.
TLDR; Concentrated liquidity DEXes (which are mainstream) are much better equipped for stablecoin pairs, than for volatile markets. For a project with a volatile token, it is incredibly hard to transform your token holders into your LPs, mainly because of the impermanent loss.
Let’s start with a simplified view of how a regular concentrated liquidity pool (like in Uniswap v3) works.
Liquidity Providers (LPs) deposit either X or Y liquidity (or both), concentrating it around certain price points of interest. For the price to rise 20%, for example, all the liquidity between the current price (0%) and the new price (+20%) must be transformed from X to Y (or vice versa, if the price moves the other way).
Essentially, when traders execute swaps, they replace LPs’ reserves with the other asset at the current price while simultaneously moving the price. This means that if an LP provides liquidity primarily in one asset:
When the price moves, this liquidity is exchanged for the other asset. If an LP initially provides token X, their position might entirely convert to token Y (or a combination of both if the price settles within their designated range). If the price reverts, their position will convert back to token X.
As you can see, the process is arranged so that LPs don’t earn directly from exploiting price movements, unlike market makers on traditional Centralized Exchanges (CEXes). Instead, Decentralized Exchanges (DEXes) reward them with fees collected from traders who use their liquidity to swap assets. Every time a trader swaps, a portion of their funds is held by the system and distributed among all LPs providing liquidity at the current price.
A simplified formula for calculating fee-based Returns On Investment (ROI) for LPs is Fee Profit = L * N * F, where:
Lis the amount of liquidity they provide;Nis the number of times their liquidity is completely transformed from one asset into another due to swaps (turnover);Fis the fraction of incoming swap volume held as fees (defined by the pool creator).
For example, if an LP provides $1,000 of liquidity to a pool with a 0.3% fee rate and the price slides through their liquidity range 10 times, they will earn $30 in fees (1000 * 10 * 0.003). However, it’s crucial to understand that this formula primarily reflects fee generation. For volatile assets, an LP’s overall profitability must also account for impermanent loss (which we’ll discuss shortly); true profit is closer to Fees Earned - Impermanent Loss.
This fee-centric model means that to maximize returns, LPs are motivated to provide liquidity in super-narrow ranges around the current price, enabling them to capture as many price deviations as possible and earn substantial fees. Consequently, LPs are predominantly interested in active yet stable markets, such as stablecoin pools (e.g., USDC/USDT).
Indeed, this model works extremely well for stablecoin pairs. The USDT/USDC pool (#2 by activity on Uniswap) has a daily volume to Total Value Locked (TVL) ratio of approximately 32, while the same ratio for ETH/USDC (#1 pool on Uniswap) is around 2 (at the time of this writing). This means that for the USDT/USDC pool to process the same volume as the ETH/USDC pool, it requires 16 times less provided liquidity.
But most coins are volatile, and this presents a significant problem for such a model. Let’s consider an example. Suppose an LP provided liquidity to a pool, as shown previously.
Then, the price makes a substantial swing in the direction of that liquidity.
The LP’s position is now predominantly or entirely in asset Y. If they attempt to withdraw their liquidity and convert it back into asset X, they will do so at a disadvantageous price, receiving less X than they initially had (assuming X was their starting point or benchmark).
This phenomenon is called “impermanent loss.” It’s termed ‘impermanent’ because as long as the LP keeps their position in place, there’s a chance the price will revert to its original level, allowing them to potentially recover their value in terms of the original asset composition. However, if withdrawn while the price is divergent, the loss becomes permanent, and the fees earned may not be sufficient to cover this discrepancy in value, leading to a net loss compared to simply holding the assets.
Now, instead of the “set-and-forget” model typical for stablecoin pairs, LPs dealing with volatile assets must make price predictions and actively manage their positions: concentrating liquidity when the price is stable and activity is high, and widening their range (or even withdrawing liquidity) when the price is volatile. This often requires a level of sophistication and constant monitoring that only a professional can handle efficiently, for instance, by employing derivative markets for delta-neutral strategies. While Automated Liquidity Managers (ALMs) have emerged to try and simplify this active management for everyday users by automating rebalancing and fee compounding, they introduce their own complexities, potential fees, and varying degrees of success in truly mitigating impermanent loss or outperforming careful manual strategies, and are not a panacea.
However, this volatile asset X is most likely the token of a specific project. Investors in this project are deeply invested in the price of X appreciating. Unless the project represents a well-established public good (e.g., Bitcoin, Ethereum), most of its potential DEX liquidity often resides with its own investors, who are typically “regular folks” and not professional LPs.
Considering the pronounced advantages and capital efficiency that current DEX models, particularly concentrated liquidity mechanisms, offer for stablecoin pairs, one might wonder if this inherent suitability contributes to the recent surge in diverse stablecoin projects. While many factors drive stablecoin innovation, the fact that modern DEX architectures provide a uniquely fertile ground for them — allowing for the creation of deep and efficient markets with relatively less capital and lower risk for LPs compared to volatile assets — could be seen as lowering a significant barrier to entry for new stablecoin issuers. In essence, the existing DEX infrastructure is almost tailor-made for stable assets, potentially encouraging more projects to explore this space, knowing a viable and efficient market structure awaits them.
From the perspective of the development team behind asset X, the situation looks even more challenging. If much of the token supply is with investors ill-equipped for active LPing, convincing them to provide liquidity is difficult, as few are willing or able to engage in the required active management. Yet, the project desperately needs substantial liquidity in its pool. Deep liquidity is crucial not only for effective price discovery but also for fostering healthy trading activity by minimizing slippage for traders, making the token more attractive to use and trade, building market confidence, and making the asset less susceptible to price manipulation from large individual trades. Without it, a token can struggle for legitimacy and adoption.
So, development teams often face a difficult choice: either secure significant, ongoing funding to attract and retain professional LPs, or attempt to incentivize their existing investor base to provide liquidity, often without them fully understanding the risks of impermanent loss. To navigate this, many projects resort to costly strategies like offering substantial additional token rewards (liquidity mining) to LPs. While this can temporarily boost liquidity, it often proves unsustainable, potentially leading to “farm-and-dump” scenarios once rewards diminish, and may not foster genuine, long-term market depth. Other approaches, such as building Protocol-Owned Liquidity (POL), offer more control by having the project itself provide or acquire liquidity, but these require significant upfront capital or complex bonding mechanics, presenting their own set of trade-offs and may not be feasible for all projects. The core issue often remains: encouraging liquidity provision from individuals whose primary financial interest (price appreciation) can be undermined by the very act of providing that liquidity in volatile conditions.
This creates a fundamental misalignment:
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Liquidity Providers (especially professionals or those focused purely on LP yield): Prefer price stability for asset X to maximize fee income relative to impermanent loss. Their risk management often discourages holding large, volatile, undiversified positions or having a strong directional bias on the token’s price itself.
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Token Investors (including team members and community): Desire the price of X to appreciate significantly and typically hold substantial amounts of X with that expectation, making them vulnerable to impermanent loss if they LP without fully understanding its dynamics.