Sudoswap & NFT AMMs

October 19th, 2022

Real product innovation happens in the bear market. Or so they say. Sudoswap is potentially one such moment in Web3 history. People always complain that NFTs are illiquid, and yet if Sudoswap (or NFT Automated Marketmakers, aka AMMs, generally) takes off in the way I think it will, then we’re about to see non-fungible tokens become more fungible.

This has potentially massive implications for the NFT industry in terms of pricing, expected returns, & royalties, but to understand where we’re heading, we first need to understand where we’ve come from.

Article Outline

What is an LP? A brief History of Time
The NFT Problem
The Missing Link
To The Future
TL;DR

What is an LP? A brief History of Time

Coming from a TradFi background, there were a couple of mind blowing moments for me as I fell down the Web3 rabbit hole. One of my most vivid of such moments: when I came across Uniswap and AMMs. My jaw dropped.

In TradFi, market making is probably the toughest game in town (uncoincidentally because it’s the most profitable). Traditionally, it was done by the guys in the jackets standing around hollering at the stock exchanges.

These people would take orders from buyers & sellers and match them off against each other. If I can find a buyer of 100 shares of Apple stocks and then a seller of 100 shares of Apple stocks and match them together, taking commissions on both sides, then happy days.

But what if the buyer only wants to buy 90 shares and I have to wait 5 minutes to find another buyer for the last 10 shares? What happens if the market crashes in those five minutes? Market makers get paid to compensate them for holding a little bit of risk during the time it takes to buy & sell. They get paid for providing that liquidity.

As we all know, the guys in coats got crushed by the computers. High frequency trading firms (“HFT”) came along & ate their lunch. Companies like Citadel, GetCo & Jump Trading dined out on becoming the liquidity providers (“LPs”) for the global stock markets.

They are the kings of Wall Street, sucking up global math talent with all their PhD quants. Only the smartest and brightest work there & earn the big bucks. All the drama that was captured beautifully in Michael Lewis’ Flash Boys. They became the “big swinging dicks,” the lions of the ecosystem preying on slower, weaker participants.

In crypto, Centralized Exchanges (“CEXs”) were their heir-apparents. The likes of Coinbase, Binance, and FTX were just re-running the HFT playbook but for BTC, ETH et. al. They are the stock exchange and the market maker all rolled into one. Sucking in all of the TradFi math talent to provide their machine learning algos more retail fodder to trade against.

So why my jaw dropped for the first time seeing a Decentralized Exchange (DEX) was because I saw that in an instant, Web3 had just done away with the big dogs. In a stroke, it’d wiped out a need for the market makers.

So fitting for a movement that began with Satoshi’s riposte to the banks of the GFC era, this decentralized liquidity provision was now showing the middle finger to the HFTs too: “No thanks. We don’t need you guys here either. We got this…k thx bye.”

Suddenly, any chump with a keyboard or phone was back in control. I can provide liquidity on both sides of USDC and ETH if I wish and the AMM takes care of the math for me of what price to buy & sell at.

Sure, there’s still risk. Anyone who’s ever experienced impermanent loss by providing liquidity has learned this lesson painfully. LPs still favor the mathematically inclined.

When you provide liquidity, you’re still essentially short volatility. You don’t want to get left holding the bag when one side of the assets you’re providing liquidity for is now worth zero. You’ve still got the same problem as the guys in the stock exchange holding Apple when the market crashes.

But now, if I have some insight that a market will be relatively stable across a particular part of the liquidity curve, I can provide liquidity without the need of an army of quants with high-spec servers co-located in exchanges running lightning fast code in C++. Decentralization indeed.

The rise of AMMs with Uniswap and the subsequent vampire attacks of Sushiswap is a worthy story in itself but outside the scope of this piece, other than to serve as reminders that it’s been an inexorable rise & one of the biggest use cases for crypto.

The NFT Problem

AMMs work great for fungible ERC-20 tokens, providing a guaranteed exit liquidity for many pairs. As an LP providing USDC-ETH liquidity, I don’t need to care about whether Seller A provides me 1 USDC or Seller B provides me a different USDC token, because the USDC tokens are fungible.

ERC-21 tokens (or NFTs) present a different problem, however. Traditional thinking was that you couldn’t LP an NFT collection, for when Seller A provides me 1 monkey JPEG it’s not the same monkey JPEG that Seller B provides me. It might be worth less, and then as an LP I’m left holding the bag on the value delta.

In the absence of AMMs for NFTs, we were left with exchanges such as OpenSea that essentially took manual bids in the form of wETH offers and manual asks in the form of ETH listings and they would get manually traded.

Eventually, Global Bid Bots were created by ‘liquidity providers’ to manually bid below collection floors and provide liquidity to immediate sellers who hope to flip the NFTs at the floor for a small spread. These providers take the risk of bag holding in volatile markets for a small fee. This is shown clearly in the Liquidity Theory of NFTs (reproduced below).

But this model is back to our old problem of HFTs. Those with access to sophisticated programing bots and large computing resources can build and operate these bots, but it’s not decentralized.

The Missing Link

The point that gets missed, however, with the non-fungible element of NFTs is that at the end of the day, there’s not that much difference in the vast majority of a collection’s fungibility. Anyone who has ever looked below ‘inverse J curve’ of rarity for an NFT collection knows the story.

If you have a grail or a 1/1, then these can be highly illiquid and yet highly profitable if you can find the right whale to buy it off of you. However, once you get past the top, say, 5-10% of a collection, the market says that rarity ceases to really matter.

See below for BAYC - Once you’re past 1k rarity, the curve is basically flat. After all, who really cares if they buy the 2k ranked rarest APE or the 3k ranked rarest? It becomes basically irrelevant the further down the curve you go.

Therefore, the vast majority of an NFT collection is largely fungible. If I provide a pool of BAYC NFTs to purchase at a certain price, sure you might buy my 3k rarest off my pool and dump me a 9k rarest back, but do I really care? Not if I’m paid enough for my liquidity provision, and therein lies the genius behind Sudoswap & other NFT AMMs.

Sudoswap was not the first (similar predecessors include NFTTrader and Swap.Kiwi) but it arguably has been the most successful. As of October 2022, Sudoswap has processed 30k ETH in volume involving 44k unique wallets and over 100k NFT transactions.

Suddenly, I as the dumb user with just a keyboard or phone am back in control. As per the below Sudoswap screen, I set my terms of where to buy and sell, deposit my NFTs, and boom: I’m able to earn fees off NFTs for providing liquidity.

This is a slightly easier setup for the casual user to understand than, say NFTX, which has made strides in getting some collections like CloneX to be liquid, but which requires a greater degree of understanding of where NFTs get swapped out for ERC-20 tokens.

Make no mistake: an LP position for NFTs is still a complex short vol view on the NFT collection. If the NFTs go to zero, you’re left holding the bag. Likewise, the ‘crash up, grind down’ propensity of NFTs means you’re likely to be left holding ETH if there’s a big news event on the collection.

However, just as with Uniswap LP staking, if you find an NFT collection you’re confident in over the long-term & happy to bag or, even better, think is likely to range for a good period of time, then providing liquidity is a profitable strategy.

Built into the sudoswap system is a ‘buy low, sell high’ strategy where you’re picking up assets at favorable prices and selling them back when demand is high, all while collecting your fees for any chop back and forth in the range.

To The Future

The dream for DEXs was that eventually they’d kill the CEX - that the future would be entirely decentralized. It seems, however, that in reality what’s happening is that DEXs have instead just become another animal in the larger crypto ecosystem.

Arguably, DEXs are better for some things, like providing liquidity on lesser-used tokens but maybe still having more slippage on more liquid tokens and lacking the features (like advanced stop/profit orders) of CEXs.

The lions of the ecosystem never went away when DEXs came into being, either. They are still out there preying on those with less information and fewer resources. The retail guys providing liquidity on AMMs have arguably just become another source of prey.

For example, the Dune report below shows the ‘toxicity’ of Uniswap AMM flows where the future price for an LP is worse than the execution price. This shows that many passive LPs are just getting arbed over and over, losing money on a consistent basis for the wETH/USDC pair.

This shouldn’t be seen as a warning to stay away from NFT AMMs, however. ETH/USDC is a massively traded crypto pair, and you can be arbed by many other more sophisticated players who are trading these pairs NFTs, though, are the frontier, and where there is immaturity, there is opportunity.

Maybe one day you will be arbed providing liquidity on AMMs for NFT,s but for now you may currently have a window where the good times will continue to roll for the right trades. There are also many more collections (pairs) on the NFT side such that it might become impractical for sophisticated players to ever enter in sufficient size, leaving a natural barrier to entry for the right retail NFT LPs.

So if we look to the potential future for NFTs with this new entrant to the ecosystem, what can we foresee? We will still have the beasts we recognize, the HODLoors and the JPEG flipoors, but there’s now a new breed of NFT animal:the liquidity providoor.

I envisage that similar to Uniswap not killing the CEXs, Sudoswap will not kill the centralized NFT marketplaces like OpenSea, since not everyone will want to provide liquidity. There are also many integrations still to be built out for Sudoswap, which will increase the visibility of listings on the platform.

The likes of aggregators such as Gem.xyz have started to include Sudoswap listings, but trading platforms such as NFTNerds will need to include them for the full potential of AMMs to be reached. These are relatively small and soluble problems, and in time the potential of NFT AMMs will likely be reached.

Thus when we reach such a state & the floor of major collections becomes much more liquid as a result, then we can expect a real decrease in the illiquidity risk premia that we expect to receive from NFTs - especially at floor levels,NFT levels although arguably this premia will always still exist for grails (how many NFT Whales can realistically set up sudo pools with their 1/1’s?).

The largest impact we have seen to date with Sudoswap is, unsurprisingly, its reigniting of the royalty argument. In the Sudoswap model, it’s the LP that collects fees, not creators in the form of royalties. It is only fair to reward LPs for the liquidity risk they take, but many have questioned the viability and ethics of taking this cut out of the creator’s pie.

It is somewhat ironic that the AMM - the ultimate Web3 tool to deliver us from the centralized clutches of Wall Street - is now being used to stick it to the little guy creators who suffered so much under Web2 and deemed royalties a main draw to NFTs. However, if we view liquidity providoor fees as a function of the liquidity risk they take, adding back royalties to the NFT is essentially just increasing the illiquidity and therefore the risk borne by the LP, and indeed the risk premia that an LP will demand to bear such a risk.

Therefore, I don’t see liquidity provider fees and royalties as mutually exclusive personally, and so I hope as NFT AMMs find their place in the ecosystem, as they should, we can continue to provide useful income to both ecosystem participants for their services in building our new decentralized future.

TL;DR

NFT AMMs like Sudoswap are here to stay.
Similarities to DEXs can be drawn with similar risks.
NFT AMMs are expected to reduce illiquidity risk premia.
Royalty & liquidity fees are not mutually exclusive.

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