Summary
Osmosis is an automated market maker (AMM) built on Cosmos that enables cross-chain transactions through Inter-Blockchain Communication (IBC). This gives the protocol an added layer of interoperability and composability. Unlike most existing AMMs, Osmosis is deeply customizable and allows developers to leverage many different changeable parameters to build truly unique AMMs that can dynamically fit a variety of outcome goals. Ultimately, Osmosis enables developers to design and deploy custom AMMs that can quickly adjust to changing market conditions and allow market participants to decide which iterations provide the most optimal results, rather than relying on the protocol itself.
Overview
Most existing AMMs are confined to operate within the native blockchain in which they were originally built. While there are workarounds, this places certain limitations on developing a truly chain-agnostic AMM that can execute transactions across different networks seamlessly and efficiently. In addition, while the features between AMMs can vary quite significantly, they are often hardcoded into the protocol, leaving a rigid infrastructure that is unable to adapt quickly to the demands of an ever-changing market. Developers very rarely have the freedom to change key parameters like swap fees, token weights, let alone the more infrastructure-drive values such as the curve algorithm or TWAP calculation.
For instance, popular AMMs like Uniswap V3 allow users to create liquidity pools with different fee sizes, specifically between 0.3% and 1%. This creates a bit of a quality of life improvement for casual users in that they are not required to spend time tinkering with the underlying tokenomics and implications of a given set of LP fees. It also provides some flexibility and is useful in cases that involve more exotic token pairs. For more sophisticated users, however, additional parameterization might be useful to better react to changing market conditions. This approach also shifts the focus of fee structures away from how common or how rare a given token pair is to be more comprehensive by including other factors such as slippage and market volatility. Ultimately, there is no single solution that fits all AMM design goals, and an additional layer of customization helps developers fine-tune optimal strategies around fees and liquidity provision, and takes into account other factors that may directly impact success of the AMM.
Osmosis attempts to solve these shortcomings in many different ways. To begin, the protocol was developed using the Cosmos SDK which allows it to operate across chains. This gives Osmosis access to any chain built on the Cosmos ecosystem which unlocks over $10B in TVL. It also allows Osmosis to integrate with non-IBC enabled chains, such as Ethereum, giving it even more composability and interoperability.
From a design perspective, Osmosis is focused on user experience and a deep level of customization. The protocol extends AMM functionality beyond simply token swaps and implements a host of other features such as bonding curves, dynamic fee swaps, and multi-token liquidity pools. It therefore enables developers to build, design, and deploy their very own AMM, fully customized with novel parameters and fully connected to the IBC ecosystem and beyond.
Some of the more interesting features include liquidity pools that are not limited to 50-50 token pair composition. Instead, developers are free to experiment with different designs, such as a 60-40 split. More broadly, Osmosis enables developers to implement changes around everything from token weights and swap fees to the AMM curve to determine which iteration works best. They also have the tools to quickly adjust these features (as quickly as one week) as market conditions change. The concept of deep customization is important because it allows for a truly decentralized AMM framework and lets market participants determine the optimal equilibrium between fees and liquidity, rather than being relegated to rigid protocol parameters that attempt to determine it for them
Mechanism Design and Tokenomics
$OSMO is the native token of the protocol and is used primarily for governance and staking. Token holders can delegate their $OSMO to a validator and receive staking rewards and voting rights in return. Once staked, token holders can engage in governance by making proposals and voting on different issues including protocol upgrades, determining the base swap fee of the Osmosis network, and allocating liquidity mining rewards. More features can be added to voting as the scope of governance expands over time.
One particularly interesting feature of Osmosis governance is that it is tied to liquidity pool rewards provision. That is, token holders that participate in governance are responsible for selecting which liquidity pools are eligible to receive liquidity rewards. This is an interesting mechanic in that it allows stakeholders to dynamically incentivize liquidity pool provision and determine strategies that constantly evolve over time, adjusting to changing market conditions. An obvious downside, however, is that this assumes that token holders, given that they have a long-term vested interest in the protocol’s well-being, also know which stratagems to implement to best incentivize liquidity pools. If token holders guess incorrectly, then general liquidity volumes could suffer as liquidity providers exit to other AMMs to enjoy more favorable conditions. If they guess correctly, then Osmosis would presumably be able to poach liquidity providers from other AMMs, given that their native reward-incentive scheme is superior to competitor models.
The max supply of $OSMO is capped at 1,000,000,000 with a 9 year distribution schedule. Currently, 325,000,000 tokens have been minted into the current supply of which, roughly 280,000,000 (or 28% of max supply) are in circulation.
Token distribution is heavily centered on staking rewards and liquidity mining, with these two allocations making up 70% of the total distribution. This was a strategic decision by Osmosis to help bootstrap the network and gain traction. Staking rewards and emissions begin to flatten over time, which reduces token dilution, but also reduces token holder incentives.
Macro View
Currently there is over $1.6B in TVL, with about a 50% increase since early February 2022. As Osmosis continues to expand with and beyond the Cosmos ecosystem, the potential for more TVL grows with it.
Daily volume is around $70M, which places Osmosis in the top 15 highest volume DEXes. One particularly attractive feature of Osmosis, besides its chain-agnostic underpinnings, is that as creative AMM developers join the space and begin to experiment with truly novel designs, this could begin to attract more trading volume, since end users and liquidity providers will seek to reap the benefits.
One area to note is that nearly 85% of the total daily volume is derived from four assets: $OSMO, $ATOM, $UST, and $LUNA. Again, one of the more promising features of Osmosis is that it is designed to be purely chain-agnostic. As more tokens enter the ecosystem, particularly ones with high trading volumes, network activity could see a significant uptick. Moreover, as Osmosis expands within the broader DeFi network, it will be interesting to see how this token composition changes over time and whether the highly customized AMMs can attract liquidity from other native ecosystems.
In addition, Osmosis has averaged well over $1B in monthly trading volume since November 2021, with nearly $1.9B in total volume for the month of March at the time of writing (03/18/22). This could also see an increase as the protocol gains more cross-chain traction.
One concern is that the current $OSMO inflation is over 92% (according to https://www.mintscan.io/osmosis). This puts significant dilutionary pressure on token holders, stakers, and validators, at least in the short-term until these rates begin to decrease over time.
Despite an increase in TVL of over $500M during the last month as well as monthly trading volume being in the $3B range in January and February, $OSMO has lagged $BTC and $ETH price movements. Part of the issue here could be related to emissions and dilution.
Finally, while the general idea of fully customizable liquidity pools gives market participants the opportunity to experiment with different parameters and fee structures, and helps delineate Omosis from other AMM frameworks, one downside is that it could spread assets too thinly across many of the same liquidity pools with the end result being insufficient liquidity on any given liquidity pool and high slippage. As users iterate through different approaches, it’s reasonable to expect that certain key parameters will be found to be optimal, however, in the short term this discovery process could have some unintended consequences. Moreover, part of the appeal of a fee-structure like Uniswap is that it is easy to understand and users have a way of knowing what to expect. Osmosis allows liquidity pools to be more experimental in nature, which again in the long run helps make them more optimal, but in the short-term may overwhelm or discourage users from engaging in the platform, particularly casual users that are not well-versed in the nuances of liquidity pool mechanics.
Further Reading and Sources
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