Before going into the details of vampire attacks, their effects on AMM, etc., let’s first look at a few highlights.
What does liquidity mean and why is it important
When you search for a cryptocurrency exchange, you often see the term “liquidity”. Open Coinmarketrate.com and you will see that many exchanges claim that they are a platform with high liquidity. This is due to the fact that it is important for its users. If platform hasn`t got enough liquidity, user can face certain problems. Thus, you will be unable to sell your coins at a price you would like to.
And vice versa, it may happen that you pay too much for a certain cryptocurrency on an exchange with low liquidity.
And so, liquidity shows how easy it is to trade a certain asset without having a big impact on the price. When an asset is easy and quick to buy or sell, we can talk about high liquidity.
In crypto world, we understand liquidity as the ease of converting cryptocurrency into fiat money, as well as the ease to convert it into another cryptocurrency.
When you buy crypto on a crypto exchnage, you, so to say, buy it from some third party. This is so because first there should be someone selling this coin. Of course, crypto exchanges also own many cryptocurrencies that they sell from their own stocks.
Not only the exchnage can provide the necessary liquidity. It may also happen that the cryptocurrency itself is not liquid enough. Thus, BTC is considered one of the most liquid cryptocurrencies. This is due to the fact that there are almost no exchanges that wouldn`t allow you to buy or to sell it. That`s why it is extremely easy to get the coin.
The team creating the cryptocurrency must ensure that it can be traded on as many exchanges as possible. Besides, the exhcnage should be easy to use.
Thus, a decentralized exchange (DEX) is considered less user-friendly than a centralized exchange. This is due to the fact that it is necessary to go through several steps to use DEX, which can scare off beginners.
One of the ways to measure the liquidity of a particular market is the spread of supply and demand. The bid-ask spread shows the difference between the lowest demand and the highest supply. The smaller this difference, the better the liquidity.
At the moment when the prices that buyers are ready to pay are close to the prices sellers set for the coins they sell, the asset can be easily sold.
When the difference is large, the market is often also less liquid. This is because the prices that buyers are willing to pay, in this case, are much lower than the prices that sellers are willing to pay. In this case, few transactions occur because buyers and sellers cannot agree on a price.
Why is liquidity important?
Of course, it is important that you can buy cryptocurrencies using payment methods such as payment systems and credit card. But when you start looking for a cryptocurrency exchange, you should pay attention to some other aspects.
For example, it is important to choose a crypto exchange where there is enough liquidity. This can be a disadvantage if there is not enough liquidity on it. If the crypto exchange offers sufficient liquidity, you can trade this cryptocurrency at the best market price.
What happens if there is not enough liquidity? Well, it may happen that someone has a lot of XRP coins and wants to sell them all at once. However, it is necessary to find a buyer for these coins. If the quantity is too large and the buyer is not found, the seller has to ask for an increasingly lower price. If he doesn’t, he won’t get rid of XRP either.
This can lead to problems for the seller and the market. The seller naturally wants to sell his coins at the best price. However, if no one can be found for this, there is a high probability that the price will fall and the seller will suffer losses.
Another consequence is the effect on the market price. If an incredibly large number of coins are put up for sale at the same time and they are not sold, the market price will drop. This is due to an oversupply.
And so, if the cryptocurrency is liquid, it means that it can be easily and quickly traded at the best market price. Not only the currency itself must be liquid, but the exchange where you can buy it must have high liquidity.
We have sorted out the first point. Let’s move on…
Understanding DEX and AMM
DEX is a platform that facilitates the trading of cryptocurrency tokens without an intermediary. This means that users are not required to undergo KYC procedures, and trading with the platform is carried out pseudonymously. However, DEX cannot be completely anonymous, since all transactions are recorded in the blockchain.
There are two main types of DEX:
1.DEX based on the order book: users can buy and sell orders at their chosen prices, orders are recorded in the central register, and users take custody of their assets.
- DEX based on a liquidity pool or AMM: Most DEX based on a liquidity pool use automated market makers (AMM), which algorithmically determine asset prices based on the ratio of tokens in the pool.
Trades are carried out against a smart contract or a liquidity pool (LP), which are pools of token pairs that can be exchanged for each other. Some liquidity pools contain more than two types of tokens or pairs of cryptocurrencies.
AMM is essentially smart contracts that manage money pools, allowing traders to exchange tokens. Traders pay a minimum fee to the liquidity providers who finance the pool, and this creates a win-win situation: liquidity providers are rewarded for providing liquidity, and transactions go smoothly, regardless of supply and demand.
And now let’s move on to the most important thing…
What are “Vampire Attacks”?
The concept of a vampire attack in cryptocurrency is quite simple. It is aimed at creating an identical or similar protocol, which is endowed with a more profitable and attractive incentive mechanism.
The development of a protocol identical to another DEX based on a liquidity provider (if the smart contract code is open or visible on Etherscan) with a more profitable incentive mechanism will definitely attract investors looking for better rates.
Why do “Vampire Attacks” occur? Oh, this explanation is as old as the world: the idea of a vampire attack is to lure users away from the protocol they originally used to your own, more profitable protocol.
The vampire attack aims to get the three most important things from the popular protocol:
- Trading volume
One of the most famous vampire attacks was carried out by SushiSwap, which offered better liquidity provider rates than UniSwap, the dominant DEX platform. This prompted many investors to withdraw liquidity from UniSwap and transfer it to SushiSwap.
Vampire SushiSwap Attack on Uniswap
Sushiswap was created by an anonymous person named Chef Nomi. By offering its own SUSHI token as a reward for LP, SushiSwap wanted to create a decentralized, community-driven platform to compete with UniSwap backed by venture investors.
UniSwap offered LP tokens as a reward for providing liquidity on the platform, and SushiSwap’s strategy was to encourage them to put these LP tokens on SushiSwap in exchange for SUSHI tokens. SushiSwap used a rather aggressive approach, offering 1,000 SUSHI tokens per Ethereum block distributed across various UniSwap pools, including ETH pairs with SNX, LEND, YFI and LINK. After the start of trading, SushiSwap continued to provide SUSHI tokens to active liquidity providers at a rate of 10% of the early distribution rate.
SushiSwap betting contracts and SUSHI distribution began on August 28, 2020, with initial bids reaching 1000% APR. In just a few hours after the launch, they collected more than $150 million in tokens invested in liquidity on their platform, and then experienced a parabolic growth from about $280 million to $1.8 billion in total blocked value (TVL) in just 11 days. As a result of the transfer, liquidity in the amount of about $800 million instantly flowed into SushiSwap, and TVL UniSwap decreased by about $400 million. This was done by exchanging UniSwap LP tokens for assets placed on UniSwap.
How to Prevent Vampire Attacks
A few considerations that can help prevent such vampire attacks are as follows:
- Adding a lock-up period for new liquidity providers when they cannot withdraw their capital for a certain time.
- Limiting the number of LP tokens that each user can withdraw over a certain period to prevent mass migration of users and liquidity.
- A voting mechanism where users can tell which protocol they would like to use.
These solutions should help reduce most, if not all, of the risks associated with vampire Attacks and ensure healthy competition between protocols.
Such attacks are quite predictable in the case of large, venture-backed players, such as UniSwap. Any protocol in which capital can leave quickly is at risk because LPS may be better incentivized to perform a similar function in another protocol.