Thread by @0xdoug

1/ A traditional AMM (like PancakeSwap where SQUID traded) works by always keeping the two sides of the pair in exact balance (in this case SQUID and BNB).

Let's say the price of SQUID in the pool starts at 5.0 BNB. That means the AMM has 5.0 BNB tokens for every SQUID tokens.

https://twitter.com/Pigeonomics/status/1455359696060264451

2/ User goes to "sell" SQUID. They send their tokens to the pool. The AMM now says "I have too much SQUID and not enough BNB". It corrects by a mixture of 1) moving the exchange rate down and 2) sending out its excess BNB back to the seller. Until it's back in line.

3/ The more SQUID a user sells relative to the size of the pool, the more the AMM has to adjust the price to restore balance... And the more BNB reserves the user takes out of the pool.

4/ At small sizes this behaves linearly. A user who sells 1% of the SQUID of the pool will push the price down by about 2% from 5.0 to 4.9. Their fill happens almost exactly halfway between the starting and ending at 4.95.

5/ Because this is all a fraction, the effect goes from linear to parabolic as a user who executes increasingly large size relative to the pool the. A user who sells 900% of the SQUID in the pool will push the price down 99%, sucking out 90% of the BNB reserves for themselves.

6/ Typically a "rug" is when someone's coming in and trying to sell over 100% of the liquidity reserves in one swoop. Usually some whale who's trying to convert as much funny money into hard currency as quickly possible.

7/ The AMM makes the fill price terrible on the way down. But the rugger is thinking more in terms of just grabbing the precious hard currency sitting vulnerable in the AMM.

8/ This is why so many projects incentivize users adding token liquidity to the AMMs. The larger the liquidity pool the harder it is for anyone one party to rug in size. The paradox is the larger the pool, the more "hard currency" is sitting vulnerable for would-be rug pullers.

9/ It's also a limitation of the "capital inefficiency" in classic AMMs. In some sense an AMM is like a limit order book, but you can't quote at specific price levels. You have to provide liquidity at every single level from zero to infinity or not at all.

10/ To provide liquidity for SQUID to trade around 4.5-5.5 BNB you also have to provide liquidity as SQUID falls from 4.5 to 0.00001. Liquidity providers who support normal trading are unfortunately implicitly subsidizing would-be rug pullers.

11/ Limit order books solve this dilemma by letting market makers quote large size tightly around current trading ranges. But thin out quotes at far away prices. That supports healthy trading, but forces whales to patiently work their large orders instead of spamming Tsunamis.

12/ That's why I'm really excited for the wave of innovation in next generation AMMs-- particularly around "concentrated liquidity". That kind of functionality gives liquidity providers individual control over where and when they provide liquidity.

13/ Over time as LPs get more skilled with concentrated AMMs, the economics will increasingly dissuade rug-pulls. (While at the same time improving liquidity and price discovery in normal trading.)

14/ That doesn't magically turn bad assets into good ones. SQUID was probably doomed from the start. But it will mean that instead of instant flash to zero, we'll see more normal "crashes" where price discovery takes place over hours-- not all within a single transaction.