The revolution in the financial sector took a wholly different turn with blockchain technology. It introduced decentralized systems that were  rivaling conventional financial markets. Probably one of the most innovative derivatives born from this revolution is something called Automated Market Maker-the pivotal component behind Uniswap, SushiSwap, and PancakeSwap. But just like blockchain technology is advancing bit by bit, so too is the infrastructure built around it. Introducing Virtual Automated Market Maker, or simply VAMM-the next-generation decentralized trading system for further simplification, innovation, and expansion of financial markets.

In this article, we’ll delve deep into exactly what a VAMM is, how it compares to traditional AMMs, and why it’s now such an important concept in the blockchain space. We’ll take a closer look at its potential use cases, benefits, and challenges, and ways in which it will help to define the future of DeFi.

This article was written and prepared by Lenous Protocol Team.

What Is a Virtual Automated Market Maker (VAMM)?

A Virtual Automated Market Maker (VAMM) is a blockchain-based tool designed to facilitate the trading of assets without the need for a traditional order book or a centralized market intermediary. Like a traditional AMM, the VAMM operates through a smart contract system that allows users to trade assets directly within a decentralized platform.

However, what makes a VAMM unique is its virtual nature. Unlike AMMs that rely on liquidity pools filled with tangible assets (i.e., tokens provided by liquidity providers), a VAMM operates without physical liquidity pools and instead utilizes virtual liquidity. This virtual liquidity is represented by synthetic assets or derivatives, meaning that a VAMM can enable trading in a purely virtual environment, without requiring users to deposit actual assets into a pool.

The idea behind a VAMM is to create a more flexible and scalable trading environment that can support a broader range of financial instruments, such as perpetual contracts, options, and other derivatives, all while maintaining the decentralized, permissionless nature of the blockchain.

AMM vs VAMM: Key Differences

While both AMMs and VAMMs aim to automate and decentralize the trading process, there are several key differences between the two models:

1. Liquidity Sources

• AMM: In an AMM, liquidity is provided by users who deposit their tokens into liquidity pools. These liquidity providers (LPs) earn fees from traders who use the pool. The liquidity is tangible and consists of actual assets like Ether (ETH), USDC, or other tokens.
• VAMM: In a VAMM, liquidity is virtual. There are no physical pools of assets, and trades are executed using synthetic positions. This allows for more flexibility and removes the need for liquidity providers to lock up large amounts of capital.

2. Market Mechanism

• AMM: AMMs use algorithms, such as the constant product formula (e.g., x * y = k in Uniswap), to determine the price of assets in the pool. The price adjusts as users trade within the pool.
• VAMM: A VAMM uses a similar algorithmic pricing mechanism, but since the liquidity is virtual, it is often tailored for derivative products, such as perpetual contracts or synthetic assets. This makes the pricing mechanism more complex, as it needs to account for factors like leverage, interest rates, and funding fees.

3. Use Cases

• AMM: AMMs are primarily used for spot trading, where users exchange one asset for another directly.
• VAMM: VAMMs are better suited for derivatives trading, including perpetual futures, options, and other leveraged products. This makes them ideal for more complex financial products that require synthetic liquidity.

4. Capital Efficiency

• AMM: Since AMMs rely on real liquidity, they can suffer from capital inefficiency. Large amounts of capital need to be locked up in pools, but only a fraction of that capital may be actively used in trades.
• VAMM: VAMMs are generally more capital efficient because they don’t require actual assets to be locked in pools. This allows for greater scalability and flexibility, as the system can function with less capital while still providing the same trading experience.

How Does a VAMM Work?

In perspective, it is essential to understand how a VAMM works: the place it holds within the derivative markets. While in traditional AMMs, the users trade tangible assets, in VAMMs, their main focus is on trading synthetic assets or derivatives. These are financial contracts whose value is derived from the performance of an underlying asset, such as a stock, commodity, or cryptocurrency.

Here’s a breakdown of how a VAMM typically functions:

1. Synthetic Liquidity Creation

In a VAMM, liquidity is represented by synthetic positions rather than actual tokens. When a user opens a position, the VAMM doesn’t require any external liquidity provider to supply the underlying assets. Instead, the VAMM generates synthetic liquidity through a smart contract, which tracks the price of the underlying asset and adjusts the synthetic positions accordingly.

2. Leverage and Margin

VAMMs are often used in leveraged trading, allowing traders to open positions with a fraction of the total value of the trade. For example, a trader could open a $1,000 position with only $100 of margin, using 10x leverage. The VAMM manages this leverage by adjusting the value of the synthetic position based on the price movements of the underlying asset.

3. Perpetual Contracts

One of the most popular use cases for VAMMs is the trading of perpetual contracts—a type of derivative that allows traders to speculate on the price of an asset without actually owning it. Perpetual contracts don’t have an expiry date, and their prices are kept in line with the underlying asset through a mechanism called funding rates.

4. Funding Rates

In a VAMM, funding rates are used to keep the price of synthetic assets in line with the actual market price of the underlying asset. If the synthetic price deviates too much from the real price, the funding rate incentivizes traders to adjust their positions, bringing the prices back into balance.

5. Profit and Loss Settlement

At the end of the trade, the VAMM calculates the trader’s profit or loss based on the performance of the synthetic position. Since the liquidity is virtual, the profit or loss is settled in stablecoins or other agreed-upon tokens, rather than the underlying asset itself.

Why Are VAMMs Important?

Indeed, VAMMs are a great innovation in the field of decentralized finance, as it offers more flexible means of trading derivatives and other synthetic assets more capital-efficiently. Why? Here are some reasons why: VAMMs are very important in the DeFi world for the following reasons:

1. Capital Efficiency

Traditional AMMs require liquidity providers to lock up large amounts of capital in liquidity pools, but VAMMs don’t have this requirement. This makes trading on a VAMM ( Virtual Automated Market Maker ) more capital efficient, as traders can open larger positions with less capital.

2. Access to Derivatives

VAMMs provide decentralized access to derivative products, which have traditionally been limited to centralized exchanges. This opens up new possibilities for traders who want to speculate on asset prices without owning the underlying asset.

3. Scalability

Because VAMMs don’t rely on real liquidity pools, they are more scalable than traditional AMMs. This means they can support a larger number of traders and higher trading volumes without running into liquidity constraints.

4. Decentralization

Like AMMs, VAMMs operate on decentralized, permissionless networks, allowing anyone to trade without needing approval from a centralized authority. This is particularly important for traders in regions where access to traditional financial markets is limited.

Use Cases of VAMMs

Following are some of the use cases that seem most promising, considering the unique features VAMMs bring with them in the realm of decentralized finance:

1. Perpetual Futures Trading

VAMMs are ideal for trading perpetual futures contracts, which allow traders to speculate on the price of an asset without owning it. Perpetuals have become one of the most popular types of derivatives in the crypto space, and VAMMs offer a decentralized way to trade them.

2. Options Trading

VAMMs can also be used to trade options, which are contracts that give the holder the right (but not the obligation) to buy or sell an asset at a predetermined price. By using virtual liquidity, VAMMs can create synthetic options markets, allowing traders to hedge their positions or speculate on future price movements in a decentralized manner.

3. Leveraged Trading

Because VAMMs support leveraged trading, they are well-suited for traders who want to amplify their potential returns (or losses) by borrowing capital to increase their exposure to an asset. This makes VAMMs a popular choice for more advanced traders who are comfortable with the risks of leverage.

4. Synthetic Asset Trading

VAMMs can facilitate the trading of synthetic assets, which are financial instruments that mimic the price behavior of real assets without requiring ownership of the underlying asset. This enables traders to gain exposure to assets like stocks, commodities, or foreign currencies in a decentralized manner.

Benefits of VAMMs

VAMMs offer several key advantages over traditional AMMs and centralized exchanges:

1. Reduced Capital Requirements

Because VAMMs don’t require liquidity providers to lock up large amounts of capital in pools, they allow for more capital-efficient trading. Traders can open larger positions with less capital, enhancing the overall efficiency of the market.

2. Access to Complex Financial Products

VAMMs expand the range of products that can be traded in a decentralized manner. By supporting perpetual contracts, options, and other derivatives, VAMMs enable DeFi traders to access more sophisticated financial instruments.

3. Decentralization and Permissionlessness

As part of the DeFi ecosystem, VAMMs are decentralized and permissionless. This means that anyone with an internet connection and a cryptocurrency wallet can trade on a VAMM ( Virtual Automated Market Maker ) , without needing approval from a centralized authority.

4. Improved Scalability

Since VAMMs don’t rely on physical liquidity pools, they can scale more easily to accommodate larger numbers of traders and higher trading volumes. This makes them well-suited for high-traffic trading environments.

Challenges of VAMMs

While VAMMs offer many advantages, they also come with certain challenges:

1. Complexity

VAMMs are more complex than traditional AMMs, particularly when it comes to pricing mechanisms and leverage. Traders need to understand concepts like funding rates and synthetic liquidity to use VAMMs effectively.

2. Risk of Liquidation

Because VAMMs often involve leverage, traders run the risk of liquidation if the market moves against their positions. This can result in significant losses, particularly for inexperienced traders.

3. Market Manipulation

As with any decentralized system, VAMMs are vulnerable to market manipulation. Traders with large positions may attempt to manipulate prices or exploit vulnerabilities in the system to gain an unfair advantage.

The Future of VAMMs

As DeFi continues to evolve, VAMMs are only going to be a bigger part of this ecosystem. The capability to access complex financial products in a capital-efficient way and in a completely decentralized manner makes them an excellent tool for traders who seek out opportunities beyond simple spot trading.

What this means is that in the future, we might expect even more innovation within the VAMM space, with a set of new protocols allowing for even greater scalability, flexibility, and more user-friendly features than before. As VAMMs continue to see wider adoption, they have the potential to form the backbone of a completely decentralized derivatives market that totally changes the way we think about financial markets.

Conclusion

VAMMs are a big jump in the development of automated market makers. With VAMMs, the trading environment will become more capital-efficient, flexible, and scalable, bound to open up new avenues for traders in the DeFi space, especially in the domain of derivatives and synthetic assets.

While VAMMs come with their own set of challenges, none can deny the fact that they may change how decentralized trading is done. As the DeFi landscape continues to balloon, VAMMs could be the cornerstone for next-generation blockchain-based financial systems.

For more insights into blockchain innovations and DeFi developments, stay tuned to Lenous Protocol.