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V3 AMM Design

AMM is the counterparty of all trades. Major questions to think about while designing an AMM include how to improve the capital efficiency and the expected profit of LP (Liquidity Provider).

To improve the capital efficiency, AMM should decrease the slippage to attract more traders. Our resolution is the assembling of more funds near the index price. Furthermore, MCDEX involves the concept of "shared liquidity pool" - multiple AMMs with the same collateral can use one liquidity pool.

The profit of LP has to be maximized in order to attract more LP to provide liquidity. There are two ways to increase LP profit: One is to increase trader’s trading fee, and the other one is to reduce arbitrage opportunities. The MCDEX AMM V3 is more inclined towards the second one. MCDEX AMM V3 also applies other means to increase LP profit, including but not limited to the adjustments of spread and slippage, and the funding payment which is unique in perpetual swaps.

Definition

Variable

Definition

$P_i$

(Index Price)Index Price from Oracle.

$P_b$

(Base Price)AMM’s base price without including additional charges.

$N$

(Net position)AMM Net Position.

$N>0$

means that AMM is on long position, $N<0$

means that AMM is on short position.

$M_c$

(Cash)The perpetual swap margin of AMM deposited by all LPs.

$M_b$

(Margin Balance)Margin balance of the AMM’s account.

$M_b=M_c+P_i N$

.

$M_p$

(Position value)Position value.

$M_p=｜P_i N｜$

.

$M$

(pool Margin)The evaluation of the value of shared liquidity pool. Check formula

.

$R_f$

(Funding Rate)Funding rate. When

$R_f>0$

, long position pays funding fee to short position. When $R_f<0$

, short position pays funding fee to long position.

$S$

(Share)Total amount of pool share.

$\cal{M}$

(Market set)The market set in a shared liquidity pool.

$m$

(current Market)The current trading market in the shared liquidity pool.

$m∈\cal{M}$

.

$T_\text{hold}$

(Holding Time)Position holding time.

$T_\text{8h}$

(8 hours)8 hours.

$α$

(Spread)Risk parameter: half spread.

$0≤α<1$

.

$β_1$

(Open Slippage)Risk parameter: slippage.

$0<β_2≤β_1$

. A bigger $β_1$

increases slippage when open position.

$β_2$

(Close Slippage)Risk parameter: slippage.

$0<β_2≤β_1$

. A bigger $β_2$

increases slippage when close position.

$γ$

(Funding)Risk parameter: funding rate factor.

$γ≥0$

. A bigger $γ$

increases the funding rate.

$Γ$

(maximum Funding)Risk parameter: funding rate limit.

$Γ≥0$

. A bigger $Γ$

increases the maximum funding rate.

$δ$

(max Discount)Risk parameter: max discount of price when close position.

$ϕ$

(Fee)Risk parameter: trading fee. In practice, the trading fee consists of Vault Fee, Operator Fee and LP Fee.

$λ$

(max Leverage)Risk parameter: target leverage of AMM’s margin account.

MCDEX AMM V3 Pricing Strategy

MCDEX AMM V3 uses a price function to provide more liquidity near the index price. It uses a risk control function to adjust the spread and slippage. Meanwhile, AMM shares margin between perpetuals to further improve the capital efficiency. Finally, AMM provides the funding rate to adjust the premium/discount.

$P_i$

and its risk exposure, AMM completes base average fill price:If a trader trades

$-ΔN$

contracts, AMM trades $ΔN$

contracts. $\overline{P_b}$

is the average fill price. $P_i$

is the index price provided by Oracle. $β$

is the slippage parameter satisfying $β>0$

, in which a bigger $β$

indicates a bigger slippage. $N_1$

is AMM’s position. $M$

is the pool margin. This price function helps AMM follows the spot market price without arbitrageur. The slippage automatic decreases when LPs deposit more collateral. The derivation process of formula and

are shown in Appendix 1 and Appendix 2 respectively.

MCDEX enables multiple AMMs to share the same liquidity pool.

$\cal{M}$

is the set of markets in a shared liquidity pool. Each AMM with index $j$

has its own position ${N_1}_j$

and shares the same margin $M$

.AMM applies different slippage parameter

$β$

when the risk exposure is increasing or decreasing. When trader buys/longs against AMM, AMM is the short side ($ΔN<0$

). If AMM holds short ($N<0$

), the risk exposure is increasing. If AMM holds long ($N>0$

), the risk exposure is decreasing. The price will be:

$δ$

is max discount when AMM closes positions.When trader sell/short against AMM, AMM is the long side (

$ΔN>0$

). the price will be:Note that formula

and

contains 2 segments respectively. A trading may cross 2 segments. For example,

$N_1=10,ΔN=-15$

. The trading can be considered as 2 parts $ΔN_{seg1}=-10,ΔN_{seg2}=-5$

and denote prices as $\overline{{P_\beta}_{seg1}}, \overline{{P_\beta}_{seg2}}$

. The average price over segments is:AMM also controls a price spread. The spread is the difference between best ask and best bid price. We define the best ask/bid price as:

$α$

is the half-spread parameter. $P_\text{mid}$

is the mid-price of AMM which is determined by the current AMM position $N_1$

. The final trading price is:The figure below shows the curves of the prices.

price curves

Figure 1: Fill price for Trader. The slippage increases as AMM risk increases. Vice versa, the slippage decreases as AMM risk decreases.

After adjusting the spread and slippage, the trader pays trading fee to the AMM with the fee rate

$ϕ$

. Let $ΔN$

be the trading positions, the transaction of the fee can be described as:The maximum position of AMM is defined by calculating the AMM’s position margin:

$λ_j$

sets AMM’s max leverage of each market. AMM can open a position only if margin balance M_b is larger than the AMM’s position margin. Otherwise, AMM will cease providing liquidity and opening positions.Because AMM is the counterparty of all traders, if most traders go long, then AMM goes short (

$N<0$

), and funding rate is positive. Otherwise, if most traders go short, then AMM goes long ($N>0$

), and funding rate is negative. If there is a balance in the market, then AMM has no position, and funding rate is zero. We define funding rate $R_f$

as:The funding rate

$R_f$

is hard limited by $±Γ$

. $γ$

is the coefficient of funding rate. Funding rate $R_f$

is the ratio of position value that every position needs to collect per 8 hours. Hence if a trader holds $N_1$

amount of long position over $ΔT$

amount of time, this trader needs to make a funding payment of:Among which

$T_\text{8h}=\text{8 hours}$

.Bear in mind that the funding rate provided by AMM in formula

is always into the favorable direction for AMM. Specifically, AMM collects funding payments when it longs or shorts. AMM does not collect funding payment only when there is a tie (AMM has no position).

Features of the Pricing Strategy

In formula

we defined the base price of AMM V3. The formula has 3 major features: 1) The introduction of index price

$P_i$

, so that AMM’s price automatically follows the market price; 2) The assembling of liquidity near the index price, decreasing the slippage; 3) The solely dependent on margin balance to avoid the situation in which LP provides two types of assets.$P_i$

to direct AMM pricing. For instance, when the spot price increases drastically, AMM would not have to rely on arbitrageurs to give price but make use of the updated market price instead. In such way arbitrage opportunities can be reduced to avoid unnecessary loss in LP investment.$N$

held by AMM increases, the AMM risk exposure will increase as well. Thus, the AMM pricing will gradually moves away from index price $P_i$

, and the slippage depends on the current utilization rate $\frac{P_i N} {M}$

. When the utilization rate is low, the price will be close to $P_i$

. Otherwise, the slippage will increase.$β$

to drastically decrease the slippage. In the constant product AMM function, the slippage is relatively high in order to make sure that AMM covers 0 to ∞ price range. The V3 AMM function flattens the price curve near index price. While it improves user experience, capital efficiency is also maximized so that the fund provided by LP could be concentrated to fulfill the trading demand near the index price.price compare

Figure 2: Comparison with the constant product formula. The blue line is the AMM V3 price which decreases the slippage.

In an ETH-USDC perpetual swap, the collateral is USDC, and the underlying asset is ETH. When trader longs or shorts, the fluctuation of PNL is reflected by the collateral USDC in the margin account instead of ETH.

An essential characteristic of AMM V3 is that LP only needs to provide the collateral token to add liquidity. This characteristic simplifies the operation of LP and calculation of PNL. With constant product AMM, LP needs to provide two types of tokens, hence the PNL of LP depends on the value of these two assets, making the PNL calculation of LP unclear.

LP Profit and Risk Exposure

LP profit mainly comes from spread, funding payment, and transaction fee.

$P_i$

moves toward an unfavorable direction for AMM post trade, AMM will suffer a lost. Certain traders could take advantage of the publicity of AMM. MCDEX AMM V3 introduces the concept of an "operator". An operator is the creator of the perpetual swap as well as the one who manages risk parameters so that the risk on LP can be limited. In return, Operator receives part of LP’s profit.Trading Procedure of AMM

This section is a complete step-by-step trading procedure of AMM. If a trader trades -ΔN amount of perpetual swaps, AMM, the counterparty thus trades ΔN amount of perpetual swaps. Then:

- 1.Read price$P_i$from Oracle. Realize the funding payment using formula.
- 2.The margin$M$could change in circumstances like AMM has a PNL caused by the price change or AMM receives funding payment or trading fee. Use formulato calculate this PNL and update the$M$.
- 3.Based on AMM position and trader’s operating direction, there are 4 possibilities. Use formulaorto choose slippage parameter$β$.
- 4.Useto calculate the average fill price.
- 5.Make sure that the new position does not exceed the upper limit defined by formula.
- 6.Pay the fee. Use formula.

Peripheral

There are some peripheral issues with the pricing strategy.

Deposit

LP deposits collateral token to the liquidity pool to earn trading fees and market making profits. AMM’s margin

$M$

increases and slippage decreases when LP deposits.In order to track the proportion of LP in the pool, AMM mints share tokens when LP deposits into AMM. When LP withdraw from AMM, AMM burns share tokens and transfer collateral tokens back to the LP.

AMM keeps the increasing ratio of

$M$

as same as share tokens. Given the depositing collateral $w$

and the total shares $S$

, AMM mints $s$

shares. The AMM’s margin $M$

satisfies:Withdrawal Penalty

Withdrawing from liquidity pool increases the slippage and causes LP to suffer losses. AMM reduces the losses by charging withdrawal penalty fees.

When LP withdraw from AMM, AMM first calculates the current margin

$M_1=M(M_c,N)$

and calculate the new margin $M_2=M_1 \frac {S-s} {S}$

. Then we can calculate the withdrawal collateral w:If AMM’s position is 0, all collateral of AMM can be withdrawn. But if the position is not 0, the

$w$

will be smaller. We consider this reduced collateral as withdrawal penalty. The derivation can be found in Appendix 4.Appendix 1 The Average Fill Price

The AMM V3’s price is based on the index price

$P_i$

and its risk exposure, AMM completes base price:During the transaction, the more important thing is the average fill price when trading

$ΔN$

positions. Let the AMM position before and after trade be $N_1$

and $N_2$

. The average fill price can be considered as the used position value divided by the trading positions:When a trader trades

$-ΔN$

contracts, AMM trades $ΔN$

contracts. So $N_2=N_1+ΔN$

. We can now express the average fill price as:Appendix 2 Update M to Realize PNL Caused by Index Change

Assume no trading fees are taken, when

$P_i$

from Oracle remains unchanged, the trade does not affect the margin $M$

, so the curve of the pricing function stays the same. But $M$

will be affected in the following situations: AMM has the PNL when index price $P_i$

changes; AMM receives funding payment; LP add or remove liquidity. Therefore, AMM needs to keep $M$

updated.For example, let’s say that AMM holds long (

$N>0$

), if the index price $P_i$

decreases, there will be a loss on the long side. This loss will drag down $M$

and the slippage will increase. If trader goes long to make AMM suffer a margin closeout, AMM will have to take another loss due to the change of slippage. These two losses will result in the loss of LP.The mechanism of updating

$M$

is to simulate trades that make AMM close its position. The resulted $M_c$

will be the new $M$

. Assume the current position is $N_1$

, and becomes $N_2=0$

after a simulated closing. Use to calculate the change of

$M_c$

for each market. We get:Solve equation

we get:

Among them

$\Delta=M_b^2-2(\sum_{j \in \cal{M}} \beta_j {P_i}_j^2 N_j^2)$

Due to the fact that margin balance is positive,

$\Delta \geq 0$

can also be detected by checking $M_c$

before every trading:When

$\Delta \geq 0$

, there are 2 solutions, among which formula has an unfavorable characteristic: if

$N>0$

$M$

decreases when $P_i$

increases, which is inappropriate for long position. So, formula is disregarded and formula

is favored. AMM will avoid this situation by limiting the maximum position, we will discuss this method in Appendix 3.

When

$\Delta < 0$

, the huge loss of AMM makes it incapable of going back to the zero position status using $\beta$

. The solution is to specify a $\beta$

by the algorithm just like adding a slippage to the current trading market $m$

. Meanwhile, the AMM would stop adding more position to prevent further loss. The purpose changing $\beta$

is to allow AMM to provide single sided liquidity in dangerous situation. To get a safe $\beta$

, let $\Delta = 0$

and we can get:The

$\beta_\text{safe}$

has a minimum value $min\{\beta_\text{safe}\}=0$

. For the sake of simplicity, we set $\beta=0$

. Substitute the $\beta$

into the price formula , we get

$\overline{P}=P_i$

.In summary:

Appendix 3 Maximum AMM Positions

AMM has a limited market making depth to keep the position under the max leverage when the position increases. The maximum position is subject to:

- Condition 1: keep a positive price in.
- Condition 2: The margin balance is limited by leverages according to.
- Condition 3: Prevent Δ<0 in formula.

The first condition is already solved the first edge point:

To find the other edge points, we can simulate an opening position process assuming the AMM has no position until one of the above conditions is break. The position

$N_2$

at this moment will be the maximum positions it can holds.Let

$N_1=0, M_{c1}=M$

to simulate the situation when AMM’s position is 0. We assume only the current trading market $m$

is increasing the position until $N_2$

while the other markets $j,j∈M,j≠m$

keep their positions unchanged. The final cash $M_{c2}$

will be changed to:$λ$

can be expressed as:Solve this equation we get the maximum long position is:

The maximum short position is:

$Δ=0$

in formula while substitute

$M_c$

as $M_{c2}$

, we get the maximum long position is:The maximum short position is:

If

$2M^2-\sum_{j \in \cal{M}, j≠m} \beta_j {P_i}_j^2 N_j^2<0$

, the other markets $j, j∈M,j≠m$

already reach the maximum positions. In this case, the current trading market cannot open position anymore.$N_\text{max}$

and maximum short position $N_\text{min}$

are:Appendix 4 Withdrawal Penalty

When AMM’s position does not equal to 0, there is a risk-free means for LP to arbitrage: The LP can go long, withdraw, go short, he will profit without bearing any risk. To prevent this situation, we can fix

$M$

before and after withdrawal (except for the withdrawal part).Given the amount of shares that LP wishes to burn is s and the collateral he will withdraw is

$w$

, the AMM’s position is $N$

, the total shares is $S$

and AMM’s margin is $M$

. AMM first calculates the current margin $M_1=M(M_c,N)$

and calculate the new margin $M_2=M_1 \frac{S-s} {S}$

. We can get the withdrawal collateral $w$

by solving $M(M_c-w,N)=M_2$

:The withdrawal request may fail if LP removes too much liquidity and violates formula

. We can get the minimum

$M$

in formula by substitute

$M_c$

in it to formula . So that

$M_2$

must larger than the minimum $M$

to satisfies formula .

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Definition

MCDEX AMM V3 Pricing Strategy

Features of the Pricing Strategy

LP Profit and Risk Exposure

Trading Procedure of AMM

Peripheral

Deposit

Withdrawal Penalty

Appendix 1 The Average Fill Price

Appendix 2 Update M to Realize PNL Caused by Index Change

Appendix 3 Maximum AMM Positions

Appendix 4 Withdrawal Penalty