DYMMAX liquidity pools and how do they function
To understand the mechanisms inside the DYMMAX protocol, we want to talk first about the classic mechanism for maintaining the option contract quotes on centralized exchanges. This will allow you to visually feel the difference in the proposed technology.
Standard quotation mechanism
On such exchanges as CME, NASDAQ, NYSE, there are market makers — participants who have signed an agreement with the trading organizer, an obligation to maintain buy/sell orders for a certain asset for a period not less than specified in the terms of the contract. Each contract, depending on liquidity, has the maximum possible spread set by the exchange for market makers, as well as the time and volume of orders in the order book. Due to the fact that the exchange is a very complex and high-speed SQL cluster, all operations take place in a very short period of time. For example, the transaction takes less than 30 ms. This speed of interaction allows market makers to quickly rearrange or delete orders depending on market fluctuations, and quickly move after the price, and so not to create price discrepancies for arbitrageurs. However, during strong falls, such as the fall of the American market in March 2020, many market makers left the market and the liquidity of the instrument fell sharply, which did not allow traders to close their positions or their closure was carried out with a huge spread on orders set by arbitrageurs. At such moments, losses from a price decline and a lack of liquidity in the order book accumulate, which is a critical factor while also having futures or sold uncovered options in the portfolio. This can lead to a margin call (forced closing of positions by the broker at any prices in the order book). All these risks are assumed by the participant who wants to trade in the financial market.
Quotation in decentralized protocols
The mechanism described above is not suitable for decentralized protocols, since the transaction speeds are many times lower, and each reordering requires commissions payment, which increases the market maker costs to enormous values. An interesting solution is applied in the Uniswap decentralized token exchange protocol, which combines tokens and cryptocurrencies into pools, issuing protocol tokens instead. But due to the fact that the determination of the price of a particular token is tied to the balance of the pools, it is required to add assets in equal proportions. For example, if a participant contributes tokens to the ETH / USDT pool, then he must deposit them in equal proportions, which forces users to convert assets into less interesting ones in terms of keeping them in the portfolio. Of course, now protocols there are protocols that take over the conversion, but we are interested in the very mechanism of the automatic market maker (AMM).
АММ in DYMMAX protocol
In the process of designing and testing the mathematical model of the protocol, we wanted to provide the participants with a platform that does not require constant external intervention. An important element of the protocol was the creation of a mechanism that affects the prices of options, in addition to the distribution of orders from buyers themselves.
The whitepaper of the protocol describes in detail a model that allows you to create instruments whose behavior in a certain range is completely similar to the European Call and Put options. For clarity, let’s consider an option strategy that corresponds to a Call option and is called Bull Spread in the protocol.
As we can see from Chart 1, the largest payments are made in the upper states. Accordingly, the prices of options in the auction will depend on the distribution of payments by states, and the preponderance of orders for one contract will change prices throughout the auction.
Chart 2 clearly shows the distribution of payments for a balanced auction, in which there is an equal number of bids for all contracts.
To reduce the impact of the discrepancy in the number of orders, we decided to introduce liquidity providers, since the parimutuel betting with fixed odds model implies the presence of participants with certain payments. We can use this component to create liquidity pools. Let’s take a look at the simplest distribution for a demo pool.
The fact that we do not know the final payments for the liquidity component, but we can estimate them at the moment, depending on the aggregate state of the auction, allows us to perform dynamic balancing using an automatic market maker implemented in the DYMMAX protocol.
Users familiar with options trading will, of course, notice the resemblance to the “Volatility skew”. In this case, we can argue that the further the state is from the current price, the lower the probability that the price will be at this point in the future. This allows us to raise the stakes on these conditions. At the same time, as we can see from Chart 2, these states account for the greatest weight from submitted bids, which ultimately allows us to change the price balance towards parity of Call and Put options with different strikes, thereby leveling the possibility of arbitrage within the same auction.
For each case, within the price band and at the extreme points, we can calculate the maximum possible values of profit and loss, which allows us to calculate the maximum values for the auction as a whole. Based on this data, the DYMMAX AMM protocol controls the risks and rewards for each liquidity pool, keeping risk minimization as a priority over balancing option prices. Risk levels are initially set when the traded asset is added to the protocol and can then be changed using the DMX control token.
Pools tokenization and risk control
Since the option contracts, on which the 3 strategies offered by the protocol are built, are based on settlement options and do not provide for delivery. Due to this, only quoted assets are used in liquidity pools, for example, for the ETH/USDT pair, the liquidity pool will consist only of USDT tokens. This approach allows token holders to deposit only the token into the pool, without resorting to exchange for other tokens or more complex depositing in equal proportions.
Scheme 1 shows the path from deposition to distribution of tokens at auctions held for a selected traded pair. The process consists of several stages:
- Depositing a token from a participant to the liquidity pool;
- The emission of protocol tokens is carried out at the current rate to the base token; for example, if the pool premium is 10%, then the participant must deposit 1.1 USDT to trigger the issue of 1 dmUSDT;
- Once deposited, USDT tokens become available for use in auctions through AMM;
- Transferring USDT tokens to the auction in accordance with the current profit / loss parameters;
- USDT tokens are locked in the auction until contracts expire;
- After the contract expires, the tokens remaining after payments on USDT options are transferred back to the liquidity pool. This amount consists of the results of expiration at a given rate, as well as commissions paid by the participants.
- Free tokens in the pool can be converted back by the token holder.
A participant at any time can convert the pool tokens back to the base tokens at the current rate, which is determined by the result of the pool. Conversion is carried out in an amount no more than the current amount of base unblocked tokens in the auction.
Circulation of dmX tokens
Tokens invested in liquidity pools are prefixed with dm (hereinafter we will call them dmX tokens, where X can be any asset from the DYMMAX ecosystem), which means that the token is in the pool of a dynamic market maker and carries both potential profit, and potential risk. And it can be converted back to the base token with a premium or a discount, depending on the expiration result.
The dynamic market maker pool tokens are freely tradable and can be used in trading on decentralized platforms such as Uniswap. At the same time, a market maker may be present, which quotes tokens with a spread from the price calculated based on the current premium or discount to the base token, depending on the accumulated payments in the pool.
Role of the DMX Governing Token in the DYMMAX Ecosystem
As you may have noticed, the entire commission paid by the auction participants goes to the holders of the dmX liquidity pool tokens. The DYMMAX ecosystem simultaneously circulates various liquidity pool tokens — dmUSDT, dmBTC, dmETH, etc. — however they are all related to the DMX control token.
This connection is carried out using a simple rule: in order to add a certain amount to the liquidity pool, you must simultaneously block DMX tokens for staking for the same amount. At the same time, all holders of DMX tokens benefit from the size of the liquidity pool — the larger the size of the liquidity pool, the less DMX tokens in circulation. The same mechanism ensures the minimum size of the liquidity pool. DMX token holders who want to multiply their capital through staking must put a comparable amount in the liquidity pool.
The resulting unbreakable link between dmX and DMX tokens provides the maximum reward for active participants in the DYMMAX ecosystem — they profit from both DMX token staking and commissions paid by auction participants.