What is an AMM?

An AMM is an Automatic Market Maker:‌

Some Recent History

Uniswap V2

The basic, most simplistic principle is that you have an inventory of (say) Bitcoin and an inventory of (say) USD. Ring fence these inventories and put them in a “pool”. The price of Bitcoin according to your pool is the number of USD divided by the number of BTC in the pool.

A customer then comes to you and wants to buy Bitcoin from you. He tells you how much Bitcoin he wants. You then imagine what effect it would have on your pool if you gave him the Bitcoin and took USD in return and compute a new price. You add a little commission and execute the trade. Your pool now contains fewer Bitcoins and more dollars, so your pool’s “price” of bitcoin has gone up, and you have collected a commission.

The method of computing how much to charge for Bitcoin is called the “constant product formula”. That is that at all times we ensure that the relative inventories in the pool satisfies the formula:

K = X * Y

Where:

K is a constant which must hold before and after any transaction.

X is the amount of Bitcoin in the pool

Y is the amount of USD in the pool.

It’s straightforward to automatically compute the theoretical price of any zero-sum trade against the pool by satisfying:

X’ * Y’ = X * Y

Where X’ is the amount of Bitcoin in the pool after the transaction and X is the amount of Bitcoin before.

What I have just described is what captured the crypto world by storm with the Uniswap V2 smart contract on Ethereum.

Anyone who has been a market maker for longer than five minutes will immediately see the problems:

The liquidity in the pool is spread over an infinite space along the BTC/USD price axis, meaning that capital is inefficiently allocated.
If the price of BTC goes down permanently, the PV of your inventory drops proportionately, because a growing proportion of your inventory is held in BTC.

And the benefits:

You can leave this running and forget about it. It will always print you some level of income, because markets always move.
The pool will never run out of money. The price of BTC/USD would need to be infinite for you to run out of Bitcoin and zero for you to run out of dollars.

Uniswap V2 was a revolution in the crypto world. Suddenly anyone could be a market maker. The boot was now on the other foot - anyone could be the house. Death to the banks!

Crypto investment funds sprang into life. They simply took people’s money and put it into this strategy. Billion and billions of dollars. It captured the imagination of everyone who loves crypto for the simple reason that it works outside the banking system, which is regarded by cryptophiles as rotten to the core. People who have been in banking a long time laugh at this, but they should not. Revolutions are not fueled with facts. They are fueled by a shared narrative, and the majority of the global population, that is for example, everyone under 35 years old, feels utterly disenfranchised in the global financial system. Ironically this is most likely a result of constant regulatory interference designed to “protect” them, but I digress.

Let’s put aside for the moment that “Crypto investment funds” is another way of saying “an alternative banking system” - crypto enthusiasts are enthusiastic, not necessarily always fully cognizant of the way the World works. But, so what if they’re building another banking monstrosity? This time it’s their banking monstrosity.

Pretty soon, users of Uniswap V2 were demanding higher yields from their market making operations, so Uniswap delivered with the Uniswap V3 smart contract.

Uniswap V3

V2 AMMs spread liquidity over an infinite space of prices. But markets trade within a range, right? So let’s concentrate all that inventory so that it is fully exercised and traded against within a range of market prices.

So we add some extra variables to our pool:

Pa - the price at which our pool will have spent all of its dollars to buy Bitcoin - this is the lower boundary of the pool.

Pb - the price at which we will have sold the last of our Bitcoin for dollars - this is the upper boundary of the pool.

Now we have to change the constant product formula to cater for the new price boundaries that will concentrate our liquidity:

(X + L * SQRT(Pb)) * (Y + L * (SQRT(Pb)) = L^2

Where:

L is the square root of K, the liquidity constant.

X is the amount of BTC

Y is the amount of USD

Pa is the lower price boundary

Pb is the upper price boundary

There is a smart contract that simply buys and sells using this formula on the blockchain. This is called Uniswap V3. Today, between V2 and V3 there is $200 billion sitting in pools like this on the blockchain.

And here’s a fact that will amaze you. The crypto world does not value secrecy, patents or any of that. The source code for these smart contracts is open source. But we digress again.

So what would a professional market maker make of Uniswap V3?

We have concentrated the liquidity, so provided the market stays in range, we make more money.
If the market goes out of range on the upside we are left holding all dollars, earning no income.
If the market goes out of range on the downside, we are left holding all Bitcoin, earning no income.
Wait a minute, this is starting to sound like simply selling a continuous strip of put options…
…which makes it the perfect hedge if I happen to find myself owning a load of put options I don’t want.

And in fact, the strategy of market making spot in a trading range is the basis of the method options market makers use to hedge net long options positions in their books.

Uniswap V3 has a few more problems:

It’s on the blockchain. Blockchain transactions are reliable but they are susceptible to systemic front-running. Large players can (and do) literally bribe the miners who run the crypto network to prioritize their transactions over competing ones.
Every single transaction is 100% open to the world. Imagine running a trading floor where you announce to your competitors all your trades one minute before you make them. (see front running, above).
Transactions have associated fees. The fees are proportional to network load (who gets served first is an auction process) and smart contract computational complexity. And Uniswap V3 is by blockchain standards, complex. A trade against a pool can cost up to $100 in gas fees in busy times. Adjusting your pool in any way can cost north of $500.
There is no means to hedge the downside (or upside) risk of your liquidity pool on the same venue. So you have to split capital across venues.

Reading the above, you might be forgiven for thinking that this new revolution in decentralized finance is starting to look like the old revolution in centralized finance. The big players are going to win. The little guy can no longer afford to play, and when he does play, he’s going to be outcompeted by the big boys who are going to front run him.

On top of that, he has to be disciplined, maintaining hedges across more than one venue, automating his transactions.

Who does that?

Actually almost no-one. Not even crypto funds who ought to know better.

It is also worth noting that a professional market maker will see a Uniswap V2, V3 or Power Pool as “dumb money”. This is actually to everyone’s advantage. Read on.

PowerPools are The Answer

OK, today the opportunity before us is that there is $200 billion sitting in liquidity pools on the blockchain, being front run, often unhedged, converting market noise into trading yield. They are expensive to trade with, expensive to maintain and problematic to properly hedge.

PowerPools takes the same underlying formula and puts it into a trading robot. That robot places orders in our central limit order book that when traded against, behaves as if it were a Uniswap V3 pool that had been approached on the blockchain.

However, because our PowerPool is not a smart contract, it doesn’t consume gas fees. It is completely free to run. It is also completely free to modify, reconfigure, create and delete. None of this can be said for the blockchain version.

Our AMM also happens to pick up more market noise, so it trades more often and makes the owner a little more in trading returns.

What about the headache of hedging for crypto fund managers, or amateur liquidity providers? Well we have that covered too. The PowerPool will:

Monitor market trends and gently adjust its trading range in response.
Automatically reinvest returns to achieve compounding.
Automatically buy options to hedge against large moves.
Leak no secrets to anyone.
Never be front run.

Now the big guys and the little guys are playing on the same playing field. An actual financial revolution.

The big guys still have the advantage, because they have college degrees in finance and do this all day long, they enjoy the information asymmetry over the man in the street. So they can still justify taking a commission for their services (we built that optional rule into PowerPools too).

Fine, but How Long is a Piece of String?

This document is speaking to three audiences.

Crypto Fund Managers and little guys looking for yield - that’s the $200 billion of capital that’s out there. You guys need to come and try us. There’s no minimum and no maximum. If you’re a fund manager we invite you to drop a million dollars on us and see how you do. If you’re a little guy, you can meaningfully play with a thousand bucks. There are zero fees for using PowerPools, no lock-ups and no penalties. Make as many adjustments to your pools as you like. Create, destroy them all day long. We don’t care. Come and play. Zero cost to you.
Investors - I need a little money from you to realize this opportunity right now. We have everything built. We just need to get out there and sell it, while we continue to hire and innovate. I will give you geometric returns on your investment.
Market Makers and HFT firms. I know you guys can smell the opportunity here…

First I’ll cover the opportunity for the HFT guys and systematic market makers. They’ll look at this and think, “this is the very definition of non-toxic flow”. In other words, “dumb money”. And yes, compared to the incredibly complex, AI-assisted, ultra-expensive models that these guys use, the AMM strategy is dumb.

However it’s a LOT more clever than the strategy that 90% of market participants use to trade, which is a combination of fear, greed, reading tea leaves, voodoo, prayer and listening to the sermons of just about anyone who sets themselves up as a High Priest of Markets.

Robots don’t feel fear, they don’t listen to sermons and they don’t suffer from cognitive dissonance.

They stick to the rules. They outperform everyone except for the occasional savant who actually bothers to put the work in (at which point I tip my hat to Mark Baum, Michael Burry and the other unsung heroes of 2008).

So for you guys, PowerPools is going to attract the kind of liquidity you want to see. You’ll use your quantitative magic to identify that these pools are trading at the “wrong” price, and you’ll do what you do. Meanwhile you’re making the pool owners happy because you’re giving them flow. And they are making better returns than they would if they traded manually. Win-win.

Then the Crypto fund managers. You’re tired of paying all that gas, right? It’s boring doing manual reinvestment, manual hedging, maintaining margin in multiple venues. Wouldn’t it be better to do it all in one place? Well, welcome to Power Trade. Liquidity pools, spot markets, perpetuals, futures and options. All in one place. Supported by the world’s best market makers. Continue doing what you’re doing on Uniswap but do it with us. You’ll make higher returns, can concentrate capital in one platform and have the robots do all the boring stuff for you. Now you’re free to spend more time on innovation and sales. And we’ll gladly work with you to innovate.

And investors. The trading that will take place as a result of all of this attracts trading fees - a miniscule slice of the trade value charged to everyone who initiates a trade against a pool (not the pool owner!). That’s going to add up to hundreds of millions of dollars a year. Eventually billions of dollars. And having solved the problem for crypto, we’ll then move on to FX, stocks, bonds, you name it. A real revolution in finance that everyone can get behind.

You need to be in on this at the beginning. We’re going to make so much money that we won’t ever need to ask again. So this is your one and only chance to jump on this ride.

Yes, Yes… How much will I make From a Pool?

Indeed, this is the time-honored question of how long is a piece of string?

There is no simple answer, but let’s look at a couple of scenarios:

For the past three months I’ve been running a simple PowerPool with no hedging, no reinvestment and no drifting. I ran it on the ETH/USD market. I set the lower limit (Pa) to $2450 and the upper limit (Pb) to $3400. I invested $9500 into the pool in a combination of ETH and USD.

In that time the PV of the pool’s liquidity has not changed very much, perhaps up and down by $400 (a variance of about 5%). The pool has printed $936 in trading profits in that time.

Imagine this pool over one year, in the following scenarios:

Scenario 1 - Keep the pool unhedged, and crypto markets continue in the current “range”.

In this case, after a year, the pool will have printed close to $4000 in trading profits. About a 40% yield (let’s assume we don’t enable auto reinvestment for compounding).

Spectacular, yes, but there are significant risks. The market could have tanked!

Scenario 2 - Keep the pool unhedged, and crypto markets continue in the current “range” for six months and then suffer a 50% drop in value after six months, from which they do not recover.

In this case, after a year, the pool will have printed close to $2000 in trading profits. About a 20% yield, but the PV of the ETH in the pool would have dropped to ~$5000, so overall we suffer a $2500 loss in value - just over 25%. Not bad compared to simply holding the underlying, but nothing to celebrate!

Scenario 3 - Auto hedge the pool by spending 50% of our trading profits on buying 3-month 25-delta puts, the market stays in range for a year.

In this scenario, many of the puts we bought will have expired worthless and some will have expired in the money. The market has been ranging from 2450 to 3400 and the strike of the puts we have been buying every day will vary from ~$2100 to ~$3100. We have been dollar-cost averaging into long gamma all year. Options theory says that over the long run, our puts will have broken even. So we walk away with the 50% we didn’t spend on options plus the value of the still-open options positions plus the P&L of the expired options. On average, we should walk away with close to the same $4000 return on liquidity in the pool.

Scenario 4 - Auto hedge the pool by spending 50% of our trading profits on buying 3-month 25-delta puts, the market suddenly halves after six months.

OK, this is what we’ve been waiting for.

We’re six months in, so far we’ve made $2000 in trading profits and we’ve spent $1000 on buying 3-month 25-delta put options. Some of those put options will have expired, so they will be in the same category as the previous example, we can assume that we made or lost nothing on those. That leaves $500 of put options that are now in the money. Assuming we bought those options slavishly, every day, according to the rules, then we’ve picked up about 5ETH worth of puts for a cost of about $100 per ETH. These puts are protecting us in any drop beyond about $300 in ETH/USD. The market is now at $1400, down $1400 from the average of our pool’s range which was $2825. Our options have been 1-delta all the way down from $2450 (on average) and cost us about $100 each (on average). So we have in our pool:

As you can see, we have not only survived the crash unharmed, we have actually made a 12.7% return in six months. And we are all in ETH. We can now choose to adjust the pool to the new trading range, stay in ETH ready for the bounce, or any other strategy we like.

Wait, What? Why Does This work?

It works because in crypto markets, the instantaneous realized volatility of spot markets is higher than the longer-term volatility of markets as implied by option prices.

If you’re wondering whether this is true - in the long run it has to be true, otherwise market making options wouldn’t work. One of the methodologies of pricing options is the “cost of hedging” model. A market maker isn’t going to buy an option from you unless he can make more by trading the gamma than he’ll lose in paying the time decay. (OK, I’m simplifying a bit because I’m ignoring all the un-hedged crosses he gets from the flow, but the principle is correct).

If you’re reading this and you’re a market maker or HFT guy, you’ll know exactly what I mean.

If you’re not one of those guys, I’ll simplify it:

Options are the lego bricks of all finance.
There is money on the table.
For a certain class of investor, PowerPools uses systematic trading to take that money off the table and put it in your pocket.

What’s Built Right Now?

You can create a Power Pool today at https://power.trade.

Power Pools is currently at Phase IIa - which means it automatically compounds and follows the market trend.

Phase IIb is due for delivery in June. This adds auto hedging.

Prior to this you can manually hedge the pools in our options market today.

Phase III will add free analytics tools so that fund managers and private investors can model future scenarios and build the hedging strategy they need. For free.

We are always interested to hear from PowerPool users who would like to be involved in our VIP Beta program.

Thank you for your time.

Richard HodgesHead of Risk and MarketsPower TradeTG: @rhodgesTel: +376 380 212

What is an AMM?

An AMM is an Automatic Market Maker.

Some Recent History

Uniswap V2

K = X * Y

Where:

K is a constant which must hold before and after any transaction.

X is the amount of Bitcoin in the pool

Y is the amount of USD in the pool.

It’s straightforward to automatically compute the theoretical price of any zero-sum trade against the pool by satisfying:

X’ * Y’ = X * Y

Where X’ is the amount of Bitcoin in the pool after the transaction and X is the amount of Bitcoin before.

What I have just described is what captured the crypto world by storm with the Uniswap V2 smart contract on Ethereum.

Anyone who has been a market maker for longer than five minutes will immediately see the problems:

The liquidity in the pool is spread over an infinite space along the BTC/USD price axis, meaning that capital is inefficiently allocated.
If the price of BTC goes down permanently, the PV of your inventory drops proportionately, because a growing proportion of your inventory is held in BTC.

And the benefits:

You can leave this running and forget about it. It will always print you some level of income, because markets always move.
The pool will never run out of money. The price of BTC/USD would need to be infinite for you to run out of Bitcoin and zero for you to run out of dollars.

Uniswap V2 was a revolution in the crypto world. Suddenly anyone could be a market maker. The boot was now on the other foot - anyone could be the house. Death to the banks!

Pretty soon, users of Uniswap V2 were demanding higher yields from their market making operations, so Uniswap delivered with the Uniswap V3 smart contract.

Uniswap V3

So we add some extra variables to our pool:

Pa - the price at which our pool will have spent all of its dollars to buy Bitcoin - this is the lower boundary of the pool.

Pb - the price at which we will have sold the last of our Bitcoin for dollars - this is the upper boundary of the pool.

Now we have to change the constant product formula to cater for the new price boundaries that will concentrate our liquidity:

(X + L * SQRT(Pb)) * (Y + L * (SQRT(Pb)) = L^2

Where:

L is the square root of K, the liquidity constant.

X is the amount of BTC

Y is the amount of USD

Pa is the lower price boundary

Pb is the upper price boundary

And here’s a fact that will amaze you. The crypto world does not value secrecy, patents or any of that. The source code for these smart contracts is open source. But we digress again.

So what would a professional market maker make of Uniswap V3?

We have concentrated the liquidity, so provided the market stays in range, we make more money.
If the market goes out of range on the upside we are left holding all dollars, earning no income.
If the market goes out of range on the downside, we are left holding all Bitcoin, earning no income.
Wait a minute, this is starting to sound like simply selling a continuous strip of put options…
…which makes it the perfect hedge if I happen to find myself owning a load of put options I don’t want.

And in fact, the strategy of market making spot in a trading range is the basis of the method options market makers use to hedge net long options positions in their books.

Uniswap V3 has a few more problems:

It’s on the blockchain. Blockchain transactions are reliable but they are susceptible to systemic front-running. Large players can (and do) literally bribe the miners who run the crypto network to prioritize their transactions over competing ones.
Every single transaction is 100% open to the world. Imagine running a trading floor where you announce to your competitors all your trades one minute before you make them. (see front running, above).
Transactions have associated fees. The fees are proportional to network load (who gets served first is an auction process) and smart contract computational complexity. And Uniswap V3 is by blockchain standards, complex. A trade against a pool can cost up to $100 in gas fees in busy times. Adjusting your pool in any way can cost north of $500.
There is no means to hedge the downside (or upside) risk of your liquidity pool on the same venue. So you have to split capital across venues.

On top of that, he has to be disciplined, maintaining hedges across more than one venue, automating his transactions.

Who does that?

Actually almost no-one. Not even crypto funds who ought to know better.

It is also worth noting that a professional market maker will see a Uniswap V2, V3 or Power Pool as “dumb money”. This is actually to everyone’s advantage. Read on.

PowerPools are The Answer

Our AMM also happens to pick up more market noise, so it trades more often and makes the owner a little more in trading returns.

What about the headache of hedging for crypto fund managers, or amateur liquidity providers? Well we have that covered too. The PowerPool will:

Monitor market trends and gently adjust its trading range in response.
Automatically reinvest returns to achieve compounding.
Automatically buy options to hedge against large moves.
Leak no secrets to anyone.
Never be front run.

Now the big guys and the little guys are playing on the same playing field. An actual financial revolution.

Fine, but How Long is a Piece of String?

This document is speaking to three audiences.

Crypto Fund Managers and little guys looking for yield - that’s the $200 billion of capital that’s out there. You guys need to come and try us. There’s no minimum and no maximum. If you’re a fund manager we invite you to drop a million dollars on us and see how you do. If you’re a little guy, you can meaningfully play with a thousand bucks. There are zero fees for using PowerPools, no lock-ups and no penalties. Make as many adjustments to your pools as you like. Create, destroy them all day long. We don’t care. Come and play. Zero cost to you.
Investors - I need a little money from you to realize this opportunity right now. We have everything built. We just need to get out there and sell it, while we continue to hire and innovate. I will give you geometric returns on your investment.
Market Makers and HFT firms. I know you guys can smell the opportunity here…