Written by TUDJE Gabriel
Some weeks ago we released an article on “How DeFi Liquidity Pool Works”. And we talked more about the automated market-making (AMM) model commonly used by decentralized exchanges. But because Zeroloss Defi uses the PMM algorithm to provide liquidity to its users, we have decided to use this blog post to explain how the PMM algorithm works, to equip Zerolossers with the right information to help them in their trading activity.
So in this blog post, we would explain what the PMM algorithm is, how it works, and how it is different from the AMM model.
What is PMM Algorithm?
PMM stands for Proactive Market Making. It is an algorithm developed by the DODO Defi protocol that gives you a one-sided liquidity token. The PMM algorithm aims to redesign the way the AMM works, to improve capital efficiency, reduce the risk of impermanent loss, and minimize slippage for traders.
DODO is a decentralized exchange founded by an anonymous development team and two Chinese developers. DODO works as a low-slippage on-chain liquidity provider built on the Ethereum and Binance Smart Chain and powered by the PMM algorithm.
To understand what the PMM algorithm is, think of it as an inventory management strategy. When the quality of an asset becomes low, the PMM algorithm automatically increases the price of the asset to buy back the missing inventory from the market.
The PMM algorithm makes use of oracles to provide contract-fillable liquidity and gather accurate market prices for assets. It also proactively adjusts parameters such as asset ratio and curve slope, resulting in pools that are adaptable and flexible for all sorts of use cases.
In the PMM algorithm, the concept of orders do not exist but rather the supply and consumption of liquidity. Liquidity consumption is achieved by trading assets directly with the smart contract, while the liquidity pool exists as a counterparty for all users in the process.
The PMM algorithm is a very flexible and versatile liquidity algorithm that can be adjusted to meet various market-making needs. It also offers a smooth trading experience and lucrative liquidity provision opportunities for traders and investors.
How Does the PMM Algorithm Work?
The PMM liquidity algorithm utilizes oracles to minimize impermanent loss and achieve higher capital efficiency. This makes it suitable for use cases such as single-sided liquidity for bootstrapping pools and fully customizable market-making strategies that adapt to market conditions in real-time.
To understand how the PMM algorithm works, please consider the example below. Please note that this is just an example to illustrate how the PMM algorithm works.
Imagine your dad gave you $50 and 5 oranges. Your work is to make it easy for your community to buy and sell oranges whenever they want to. In order words, you are providing liquidity for the orange market in your community.
Your dad instructs you to sell the oranges for $5 each. When someone comes to buy an orange from you, you decide to add $2 and sell it to the person for $7 instead of $5. The extra $2 you added is what is called slippage. So at this point, you have $57 and 4 oranges.
So to make up for the shortage, you decide to place a pending order at $6 to buy back the orange. After buying back the orange for $6, you are now left with $51 and 5 oranges. You can see that although it costs $1 more to buy back the orange, the extra $2 received through the slippage was enough to make up for it, and help your dad make a net profit of $1.
Please refer to “Details about PMM” and “Mathematical Principle of PMM” to get an in-depth insight into the PMM algorithm. You can also refer to the blog post “Five minutes to understand the PMM algorithm behind DODO” to know more.
How is PMM Different from AMM?
Impermanent loss is one thing that differentiates the PMM algorithm from the AMM algorithm. While impermanent loss remains a big issue facing AMM, the PMM algorithm offers a solution to it, thereby giving traders the best trading experience.
Unlike the AMM, the PMM allows you to customize your trading strategy and allows you to take advantage of your human brain to actively influence a pool’s behavior.
With PMM, traders get lower slippage, project side tokens are required to provide liquidity and you need good liquidity to buy project side tokens. Many project owners face a dilemma when using AMMs to provide liquidity.
Also, unlike the AMM model, PMM makes use of price oracles and seeks to imitate human market making by aggregating liquidity near the market price.
Please refer to this article to know more.
Conclusion
DODO’s PMM algorithm brings you efficient liquidity, reduced erratic losses, and minimized trading slippage. The algorithm works using oracles to offer contract-fillable liquidity. It also uses oracles to minimize impermanent loss for traders. The PMM algorithm mimics human market trading to aggregate liquidity near the market price. The absence of impermanent loss and lower slippage sets the PMM algorithm apart from the AMM algorithm. It is this algorithm Zeroloss uses to give its users the best DeFi experience.
