AMMs are liquidity exporters. The constant product formula (x*y=k) creates toxic order flow and impermanent loss, which pushes high-volume, protocol-native assets like governance tokens and LPs onto centralized order books. This drains value from the protocol's own ecosystem.
defi-renaissance-yields-rwas-and-institutional-flows
Blog
Why AMM Design Must Evolve for Native Protocol Liquidity
Current AMMs like Uniswap V3 are built for rent-seeking, transient liquidity. This analysis argues that the next wave of DeFi protocols requires AMMs designed from first principles for the capital efficiency of permanently locked, protocol-owned pools.
introduction
THE LIQUIDITY TRAP
Introduction
Current AMMs are inefficient capital sinks, forcing protocols to outsource liquidity to centralized exchanges.
Native liquidity is a moat. Protocols like Uniswap and Curve succeeded by internalizing swap fees, but their models fail for bespoke, non-ETH assets. A protocol's treasury and user incentives must fund liquidity internally, not subsidize CEXs.
The design imperative is capital efficiency. New models like concentrated liquidity (Uniswap V3) and dynamic curves (Curve V2) are steps toward solving for volatile assets, but they remain generic. The next evolution requires AMMs parameterized for a specific protocol's tokenomics and revenue streams.
key-trends
THE LIQUIDITY FRAGMENTATION TRAP
Executive Summary
Current AMMs treat liquidity as a siloed, protocol-specific resource, creating systemic inefficiency and user friction across the entire DeFi stack.
01
The Problem: Protocol-Captive Pools
Liquidity is locked into single-use pools (e.g., Uniswap v3 ETH/USDC). This creates ~$30B in stranded capital that cannot be natively accessed by lending protocols like Aave or perps on dYdX without complex, expensive bridging.
- Inefficient Capital: TVL is high, but utility-per-dollar is low.
- Fragmented User Experience: Requires manual hopping between protocols.
- Security Surface: Each bridge/wrap introduces new smart contract risk.
$30B+
Stranded TVL
5+ Steps
Avg. Cross-Protocol Tx
02
The Solution: Native Liquidity Primitives
AMMs must evolve into universal liquidity layers where a single deposit is natively composable. Think Uniswap v4 hooks meeting LayerZero's Omnichain Fungible Tokens (OFTs).
- Single-Sided Exposure: Deposit ETH, earn fees from swaps, loans, and perps.
- Atomic Composability: Enable cross-protocol actions in one transaction, reducing MEV surface.
- Protocol-Owned Liquidity: Projects can bootstrap TVL without mercenary capital.
90%
Fewer Tx Steps
10x
Capital Efficiency
03
The Catalyst: Intent-Based Architectures
User-centric systems like UniswapX and CowSwap abstract execution. The next step is abstracting liquidity sourcing itself. An AMM becomes a generalized solver for liquidity demands across the chain.
- Dynamic Routing: Automatically sources liquidity from the optimal venue (pool, lending market, vault).
- Cross-Chain Native: Leverages Across and LayerZero for seamless asset movement.
- Yield Aggregation: Automatically rebalances deposits to highest-yielding protocol.
~500ms
Solver Latency
-50%
Slippage
04
The Outcome: Hyper-Integrated DeFi
The end-state is a financial system where liquidity is a network good, not a private resource. This eliminates the arbitrage between CEX and DEX liquidity and makes DeFi protocols inherently more competitive.
- Unified LP Position: One NFT represents cross-protocol exposure and yield.
- Zero-Friction Swaps: Users get the best rate from the entire ecosystem, not one pool.
- Institutional Onramp: Single deposit point meets compliance and capital efficiency needs.
1 Tx
Any DeFi Action
$100B+
Addressable Market
thesis-statement
THE LIQUIDITY TRAP
The Core Thesis
Current AMMs are a liability for protocols, forcing them to outsource core economic activity to mercenary capital.
AMMs externalize protocol value. The standard x*y=k model creates a passive, extractive pool that sits adjacent to the protocol. This design forces protocols like Uniswap and Curve to rent liquidity from LPs who are indifferent to the underlying protocol's success.
Native liquidity is an asset. Protocols must internalize this function. A token's primary trading venue should be a direct, non-extractive mechanism on its native chain, akin to how a company's stock trades on its primary exchange. This captures fees and aligns incentives.
Mercenary LPs create fragility. External liquidity is volatile and exits during stress, as seen in the 2022 depeg events. Protocols need sticky, protocol-aligned capital that is rewarded for long-term participation, not just arbitrage profits.
Evidence: Over 95% of DEX volume occurs on forked AMMs (Uniswap, Curve). This demonstrates a systemic market failure where the most valuable financial primitive in DeFi generates zero sustainable competitive advantage for the protocols that create the assets.
market-context
THE REALITY CHECK
The State of Play: Fragmented, Expensive, Inefficient
Current AMMs fail to aggregate liquidity across chains, creating a capital-inefficient and user-hostile environment.
Liquidity is siloed by chain. Each new L2 or L3 launches its own Uniswap v3 fork, fragmenting TVL. This forces protocols to bootstrap liquidity from zero, a capital-intensive process that slows innovation and adoption.
Cross-chain swaps are a tax. Users pay a 50-200 bps penalty to bridge assets via aggregators like LI.FI or 1inch, on top of AMM fees. This is a direct result of AMMs' inability to source native liquidity from remote chains.
The dominant model is capital-inefficient. Billions in liquidity sit idle on low-fee chains while high-demand pools on Ethereum mainnet suffer from high slippage. Protocols like Curve and Balancer cannot leverage this stranded capital.
Evidence: Over $7B in DeFi TVL is locked in bridging protocols like Across and Stargate, a market created solely to work around AMM limitations.
LIQUIDITY ARCHITECTURE
AMM Design Paradigms: Rentable vs. Protocol-Owned
Comparison of AMM liquidity sourcing models, analyzing capital efficiency, control, and economic alignment for native protocol tokens.
| Core Feature / Metric | Rentable Liquidity (Uniswap v3) | Hybrid Model (Curve, Balancer) | Protocol-Owned Liquidity (Olympus Pro, Frax) |
|---|---|---|---|
Primary Capital Source | External LPs (Mercenaries) | Mixed: External LPs + Protocol Treasury | Protocol Treasury / Bonding |
Liquidity Ownership | LP Tokens held by users | LP Tokens split between users & treasury | LP Tokens owned by protocol |
Fee Capture for Protocol | 0.0% (Relies on UNI governance) | Up to 50% via fee switches | 100% of pool fees |
Capital Efficiency (TVL per $1 of token) | $0.10 - $0.50 (requires incentives) | $0.50 - $1.50 | $5.00+ (via leverage & bonding) |
Protocol Control Over Pools | None (immutable parameters) | Moderate (governance can adjust fees) | Full (can direct liquidity, change weights) |
Exit Liquidity Risk | High (LPs can withdraw instantly) | Medium (depends on mix) | Low (locked or vested) |
Typical Implementation Cost | $0 (relies on market) | Protocol subsidy for gauges | Initial treasury capital outlay |
Economic Alignment Example | UNI token has no direct fee claim | CRV ve-tokenomics for gauge votes | OHM treasury earns yield from owned LP |
deep-dive
THE LIQUIDITY PROBLEM
The Blueprint for Next-Gen AMMs
Current AMMs fail to capture native protocol liquidity, creating a systemic inefficiency that next-generation designs must solve.
AMMs are liquidity sinks. They lock value in isolated pools, creating capital inefficiency and fragmentation that protocols like Uniswap V3 optimize but do not fundamentally solve.
Native protocol liquidity is the target. Protocols like Aave and Compound hold billions in productive, yield-bearing assets that current AMMs cannot access without forcing a withdrawal and capital loss.
Next-gen AMMs are liquidity routers. Their core function shifts from being a destination to being a mesh network that sources liquidity from lending pools, restaking layers like EigenLayer, and intent-based systems like UniswapX.
The evidence is in TVL migration. Over 70% of DeFi TVL sits in lending and staking protocols, not AMMs, proving the demand for yield-bearing collateral that current swap infrastructure ignores.
protocol-spotlight
WHY AMMS MUST EVOLVE
Early Experiments in Native Liquidity Design
Traditional AMMs are generic liquidity pools, but native protocol liquidity demands purpose-built mechanisms that align incentives and optimize for specific use cases.
01
The Problem: Generic Pools, Mismatched Incentives
Uniswap V3's concentrated liquidity is a powerful primitive, but it's a neutral tool. Protocols like GMX or Lybra need liquidity that is duration-matched and risk-aligned, not just maximally efficient for generic swaps.
- TVL Fragmentation: Billions in liquidity sits idle or misallocated relative to protocol needs.
- Incentive Leakage: Yield farming rewards often attract mercenary capital, not sticky, aligned liquidity.
- Oracle Dependency: Reliance on external price feeds creates latency and manipulation risks for native assets.
$10B+
Idle TVL
>70%
Mercenary Capital
02
The Solution: Bonding Curves as Protocol Equity
Projects like OlympusDAO (OHM) and Frax Finance (FXS) pioneered the concept of protocol-owned liquidity via bonding. This transforms liquidity from a rented expense into a native balance sheet asset.
- Capital Efficiency: Protocol mints its own LP positions, capturing swap fees and reducing external incentives.
- Sticky TVL: Bonded assets are locked for vesting, aligning holders with long-term success.
- Monetary Policy Tool: The bonding curve itself becomes a mechanism for managing native token supply and treasury reserves.
~100%
Fee Capture
3-12 Month
Vesting Lock
03
The Solution: Isolated Pools & Vault-Based Design
Aave's GHO and Maker's DAI Savings Rate (DSR) demonstrate that native liquidity requires isolated risk modules. This design segregates protocol-specific liquidity from general market risk.
- Risk Containment: Failure in one vault (e.g., a specific collateral type) does not poison the entire liquidity pool.
- Targeted Incentives: Yield can be programmatically directed to the specific liquidity tranche that needs growth (e.g., stablecoin backing for a CDP system).
- Capital Verification: Vaults can enforce whitelisted assets or specific risk parameters (LTV, concentration) at the pool level.
0 Contagion
Risk Isolation
Programmable
Yield Targeting
04
The Problem: AMMs Lack Temporal Granularity
Constant function market makers (CFMMs) like Uniswap V2 provide liquidity for the next swap, not for a specific future date. This fails protocols needing forward liquidity commitments for options, loans, or insurance.
- No Term Structure: Cannot natively create liquidity for a 30-day loan vs. a 1-year bond.
- Impermanent Loss Uncertainty: LPs face unpredictable IL over fixed commitment periods, disincentivizing long-term provisioning.
- Mismatch with Real-World Assets: RWAs have settlement cycles and maturity dates that generic AMMs cannot accommodate.
0 Days
Term Structure
High Vol.
IL Uncertainty
05
The Solution: Vesting-Locked Liquidity (veToken Model)
Pioneered by Curve Finance (veCRV) and adopted by Balancer (veBAL), the vote-escrow model ties governance power and fee shares to the duration of a liquidity lock. This creates native, time-committed capital.
- Predictable Liquidity: Protocols can rely on a known, locked TVL base for a defined period (e.g., 4 years max).
- Aligned Governance: The longest-term liquidity providers have the greatest say in protocol direction (skin-in-the-game).
- Fee Recycling: Protocol revenue is distributed back to the locked capital, creating a sustainable flywheel.
4-Year Max
Commitment Horizon
>50%
TVL Locked
06
The Frontier: Intent-Based Liquidity Routing
Systems like UniswapX, CowSwap, and Across are moving beyond static pools. They use solvers and fillers to source liquidity from the best venue—including the protocol's own native mechanisms—based on a user's intent.
- Liquidity Abstraction: The protocol doesn't need to provide all liquidity itself; it can be a privileged destination in a network of solvers.
- Cost Optimization: Automatically routes to the most efficient source (native vault, AMM, OTC) minimizing cost for the end-user.
- Composability Layer: Turns the protocol's native liquidity module into a composable primitive for the broader DeFi ecosystem.
~500ms
Solver Latency
-20%
Avg. Cost
counter-argument
THE INCENTIVE MISMATCH
The Counter-Argument: Is This Just Ve(3,3) Again?
Modern AMM design must move beyond simple token bribes to align liquidity with protocol-native utility.
Ve(3,3) models fail because they treat liquidity as a mercenary resource. Protocols like Curve Finance and Solidly forks incentivize TVL with token emissions, creating extractive yield farming cycles. This design divorces liquidity from actual protocol usage, leading to capital inefficiency and eventual collapse.
Native protocol liquidity requires utility-aligned incentives. An AMM must reward users for actions that strengthen the core protocol, not just for providing capital. This means designing mechanisms where liquidity provision directly subsidizes protocol-specific actions like cross-chain messaging in LayerZero or intent execution in UniswapX.
The evidence is in the data. Protocols with integrated utility, like MakerDAO's PSM or Aave's GHO liquidity pools, demonstrate stickier TVL. Their liquidity serves a functional purpose beyond yield, creating a sustainable flywheel that pure token bribe systems cannot replicate.
takeaways
THE LIQUIDITY FRONTIER
Key Takeaways
Current AMMs are generic asset-swapping engines, not liquidity substrates for native protocol operations. This is the bottleneck for the next wave of on-chain applications.
01
The Problem: Generic Pools, Specific Needs
Protocols like Aave (lending) or Lyra (options) need liquidity for their unique risk curves, not just a 50/50 ETH-USDC pair. Forcing them onto vanilla CPMMs creates massive capital inefficiency and mispriced risk.
- Capital Inefficiency: >90% of LP capital sits idle, not actively backing protocol functions.
- Risk Mismatch: AMM's constant product formula is agnostic to volatility smiles or loan-to-value ratios.
- Fragmented TVL: Forces protocols to bootstrap separate liquidity silos, fracturing network effects.
>90%
Idle Capital
$10B+
Fragmented TVL
02
The Solution: Programmable Liquidity Primitives
AMMs must evolve into Liquidity Virtual Machines (LVMs)—smart contract frameworks where the bonding curve is a programmable variable. This enables native integration for derivatives, lending, and insurance protocols.
- Curve as a Service: Protocols like Panoptic define custom payoff functions for perpetual options liquidity.
- Dynamic Fee Tiers: Fees adjust based on protocol-specific metrics like implied volatility or utilization rates.
- Composability Layer: LVMs become a shared liquidity base, turning isolated dApp TVL into a network-wide resource.
10-100x
Capital Efficiency
~0 Slippage
For Native Trades
03
The Catalyst: Intent-Based Architectures
The rise of intent-based systems (UniswapX, CowSwap, Across) and cross-chain messaging (LayerZero, CCIP) demands AMMs that can act as decentralized solvers. Native protocol liquidity pools become the execution venues for complex, cross-domain intents.
- Solver Liquidity: AMMs compete to fulfill batch auctions for derivative settlements or cross-chain loans.
- MEV Capture Redirection: Protocol-specific liquidity allows value capture to be redirected to stakers or insurance funds instead of general-purpose searchers.
- Unified Liquidity Layer: Enables single-transaction operations spanning DeFi primitives (e.g., mint option -> hedge on AMM -> bridge collateral).
~500ms
Solver Latency
-70%
User Gas Cost
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