Insufficient Liquidity
(Article 1 in a series on decentralized exchanges and memecoins)
Every adult knows that the claw machines at fairgrounds are rigged. The gripping strength of the claw is weakened for most plays, or the claw doesn’t close properly, which explains why the toy usually drops before the claw reaches the chute. Kids don’t know this, so they pester their parents to have a go. The prizes look valuable and the cost appears minimal.
In this article, I am going to look at why a meme-coin launched on only a decentralized exchange (DEX) can be a lot like a claw machine.
Introduction
DEXes are usually based on something called a “bonding curve” by tokenomicists, or a “hyperbolic function” by mathematicians. That’s too much algebra for most people.
In what follows, I have specifically avoided algebra, using arithmetic examples to illustrate how DEXes work, and I have used small numbers to make things simple. I’m also only going to quote numbers to two decimal places.
To make things even simpler, I will disregard the fees that DEXes typically charge for each exchange, and I am also not going to consider gas fees. We will just look at a “pure” DEX with no extra costs to keep things uncluttered.
Note: If you find the arithmetic too hard to follow, my advice is that you should not be putting money into DEXes.
How does a DEX work?
Imagine I launch a token with a total supply of 110 coins, which we will call YOLT[1].
I decide to keep 10 YOLT for myself as a reward for my hard effort in deploying the token but to show faith in the project, I lock them in a vesting contract, which stops me from being able to trade with them for a week.
I then put the remaining 100 YOLT coins in a smart contract called a DEX. At the same time, I also add $100 worth of a stablecoin, for example, USDC. That means I have held back 10 YOLT for myself, put 100 YOLT into the DEX, and matched that with $100 of USDC.
This token pair of 100 each of YOLT/USDC forms the liquidity pool (or liquidity for short) for the DEX. By DEX standards this is a huge liquidity pool: over 90% of the tokens.
But back to how DEXes work: typically the code always keeps the amount of the first token in the liquidity pool multiplied by the amount of the second token constant. In our case, that is:
100 × 100 = 10,000
At this point, we can calculate the spot price of one YOLT, which is the USDC liquidity amount divided by the YOLT amount, or 100 ÷ 100. So a YOLT is currently priced at $1.
We can also calculate the market capitalization of YOLT, which is the amount of YOLT in circulation times the price per YOLT, or 100 × $1 = $100.
Finally, we can calculate the fully diluted valuation (FDV [2]) of YOLT, which is the total amount of YOLT that could eventually be in circulation times the price per YOLT, or 110 × $1 = $110.
All these terms: spot price, market capitalization, and fully diluted valuation do not mean what you may instinctively think they mean. The terms come from traditional finance, but even there a lot of traders and certainly the media fail to grasp the underlying fundamentals of what is going on. For example, the market cap of a token or a share is going to plummet if significant quantities of the shares or tokens are sold. This is why we talk about “value on paper” rather than real value.
Numbers go up
If a first speculator comes along and pays 10 USDC into the DEX, then to keep the product balance of the liquidity pool constant, the DEX has to reduce the amount of YOLT coin.
First mistake: the price is $1 per YOLT, so they’ll get 10 YOLT!
No, they won’t. This is where the spot price fools you.
Let’s call the new balance of YOLT in the DEX amount y.
That means:
y × 110 = 10,000
Hence y = 10,000 ÷ 110 ≈ 90.91
As a result, the first speculator receives about 100–90.91 = 9.09 YOLT, and the DEX now has a liquidity pool consisting of 90.91 YOLT and 110 USDC. As the first speculator paid $10, the price per YOLT they paid was $10 ÷ 9.09 = $1.10.
Now a second speculator comes along and also pays in 10 USDC. How much YOLT do they get, and what is the price per YOLT that they pay?
Let’s calculate the composition of the new liquidity pool first. We know the new USDC balance will be 120 (that’s 110 plus the extra 10 paid in by the second speculator), and we will call the new balance of YOLT by the letter z.
z × 120 = 10,000
z = 10,000 ÷ 120 ≈ 83.33
That means the YOLT/USDC balance has changed from 90.91/110 to 83.33/120, and so the second speculator receives 90.91–83.33 = 7.58 YOLT.
That means the second speculator paid $10 ÷ 7.58 = $1.32 per YOLT.
The more people pay USDC into the DEX, the higher the price per YOLT becomes. The price grows exponentially. This is shown in the table below (I’ve hidden the actions of speculators 16 to 99 for brevity):
This table shows what happens when a hundred speculators come along, each paying $10. By the 100th speculator, ten dollars only gets you 0.08 YOLT, at a price of almost $120 per YOLT.
In this DEX, YOLT will never run out; it will just become increasingly expensive to buy.
At this point, the market cap of YOLT is 100 × $119.90 = $11,990.
And the fully diluted valuation is 110 * $119.90 = $13,189.
And numbers go down
The first speculator paid $10 to obtain 9.09 YOLT, and the 100th speculator also paid $10, but only got 0.08 YOLT. This meme-coin has gone up more than 100-fold, so it’s on fire!
What happens if the first speculator puts their 9.09 YOLT back into the DEX?
Second mistake: The price is $119.90 per YOLT, so they’ll get 9.09 × $119.90 = $1089.89, for a whopping $1079.89 profit!
Some of you will immediately realize that the above is wrong and that we have to do the arithmetic again. Or, if like me, you are lazy and have put together a spreadsheet, you can get Excel or LibreOffice to do it for you:
The first speculator only gets $549.97 back. Well, I say only — that’s still a healthy 55x return on their original “investment.”
Cashing out
So far our 100 speculators have each put $10 into the DEX, for a total “investment” of $1000. At this point, the DEX is a bit like a game of musical chairs with added gambling, in which the total amount of money staked by the participants remains constant ($1000), but how that stake is redistributed among the participants varies, depending on when they buy into the game, and when they cash out.
Speculator 1 timed everything perfectly, being the first to buy in, and the first to cash out, thus making approximately $540 profit. In effect, speculator 1 has taken a slice of each participant’s input — a small amount from speculator 2’s contribution, and a larger proportion from the later speculators.
Can speculator 100 make a profit, or at least get their $10 back?
Third mistake: surely they can, if they sell their YOLT now?
You should realize by now that intuition doesn’t work with DEXes. You need to run the calculations. The 100th speculator only got 0.08 YOLT for their $10. Plugging in the numbers, we find that they only get $2.41 for their pitiful YOLT holding:
Here’s a shocking fact — after the first speculator exists, no speculator from number 45 onwards can get their $10 back.
Exit liquidity
We’ve forgotten something though: I have 10 YOLT waiting in my vesting contract. What if that has become available, and I can now trade it?
Then, instead of the first speculator getting $550 for quitting the game, I get $576, and the first speculator can only get $169. That is still a profit for them, but not nearly as much, and anyone after speculator 25 will never be able to get their $10 back even if they exit immediately after speculator 1:
If the speculators exit in the same order they entered, everyone after speculator 7 will make a loss:
And look at the price per YOLT after I sell — it drops from $119.90 to $27.44 with my single trade. Even with only 10% of the token held back by me, and 90% allocated to the liquidity pool, I can cause a price collapse.
The real deal
There are projects out there where the initial liquidity pool is set as low as 2% of all the tokens. By now you should understand how ridiculous that is.
Let’s say I put 10% of the coins in my initial liquidity pool for YOLT, which is still low, but considered acceptable by many. If 100 YOLT is 10%, then 1000 YOLT would be 100%, and in that scenario, I held back 900 YOLT in my vesting contract.
Just before my 900 YOLT vest, the market cap is still 100 × $119.90 = $11,990.
After my 900 YOLT vest, token tracker sites will report the market cap and the fully diluted valuation as the same (all tokens are now in circulation), namely 1000 × $119.90 = $119,900.
What happens if I sell all of them immediately?
I’ve extracted almost all the money, and YOLT is worth a penny per token.
Furthermore, the fully diluted valuation is now $0.01 * 1000 = $10, down from over a hundred thousand dollars to ten dollars in one single trade.
Footnotes
[1] YOLT = you only live twice: once looking forward to a time you can control but not understand, and once backward to a time you can understand but not control.
[2] Here is how Coinbase defines FDV and market cap: https://www.coinbase.com/en-gb/learn/advanced-trading/what-is-a-fully-diluted-valuation-fdv-in-crypto — if you’ve read the article, you’ll understand how ludicrous FDV is as a metric, and how misleading market cap is.
Coda
If you found this interesting or useful, you’ll probably enjoy my book, Evil Tokenomics. You can find where to buy a copy by following this link.
