Detailed Explanation of the Largest DEX in the Cosmos Ecosystem: Osmosis

Written by: Jerry Sun, Messari Researcher

Compiled by: iambabywhale.eth, ForesightNews

Key Points:

• Osmosis is a DEX built on the Cosmos ecosystem with an independent and interoperable Layer1 public chain;
• It is the first application chain in the Cosmos ecosystem to achieve significant IBC trading volume and launch DEX activities;
• Its features include customizable pool parameters, Superfluid staking, and plans to incorporate anti-MEV into its underlying architecture;
• The protocol is supported by the native token OSMO, which can be used for staking and governance. OSMO rewards are also released through liquidity incentives.

Introduction

Investors believe that multichain can solve the scalability issues of blockchain, which has sparked interest in the Cosmos Network ecosystem. Cosmos, known as the "Internet of Blockchains," can accommodate a range of independent application chains. Each application chain in the network is a unique Layer1 blockchain designed to enhance the functionality of the Cosmos network.

To connect such a blockchain ecosystem, a healthy trading platform is needed. Through these trading platforms, capital allocators can gain liquidity to foster healthy markets, invest in growing projects, and direct investments toward promising opportunities.

The Cosmos network supports its own native DEX, but leading in liquidity, trading volume, and fees is the Osmosis protocol. In this report, we will explore Osmosis and its features compared to other DEXs that adopt the AMM model.

Osmosis Overview

Background

Osmosis is a DEX in the Cosmos ecosystem that supports cross-chain communication (IBC). It was founded in January 2021 by Sunny Aggarwal, Josh Lee, and Dev Ojha, with Osmosis Labs responsible for its development.

The three co-founders each leveraged their experience working in the blockchain space, having initially worked on the Tendermint protocol, known for its Byzantine Fault Tolerance consensus mechanism.

During that time, they were dedicated to the underlying architecture of the Cosmos ecosystem, engaging in various projects including the Keplr wallet. It was also during this period that they established Osmosis with the goal of building a fully customizable DEX.

How Osmosis Works

Functionally, Osmosis operates similarly to other AMMs. Liquidity pools lock tokens into smart contracts, which automatically execute trades of those tokens.

Traders' counterparts appear in the form of liquidity providers (LPs), who supply the underlying tokens, or liquidity, to these pools. In return, these LPs receive designated LP tokens, representing their contribution to the pool and measuring their share of generated returns. These are all traditional concepts.

Additionally, like many other AMMs, Osmosis relies on a deterministic pricing model to ensure that the respective weights of tokens in each pool remain consistent. In fact, almost all AMMs use deterministic pricing as it helps determine the amount of tokens in each trade. While the market pricing of any token may fluctuate, maintaining the underlying pricing formula minimizes arbitrage opportunities.

Liquidity Incentives

To ensure sufficient liquidity, the DEX has established two mechanisms to help build long-term viability: binding liquidity metrics and exit fees.

Long-term DeFi users may view the former as a traditional liquidity incentive. The mechanism for binding liquidity metrics is straightforward: LPs who add liquidity to the pool will receive rewards in the native token OSMO.

LPs can choose how long they are willing to bind their tokens. The exact amount of OSMO rewards earned depends on the duration of the binding and the amount of tokens bound, all determined by protocol governance.

Interestingly, not all liquidity pools are eligible for rewards. OSMO holders will decide which liquidity pools receive rewards. Eligible liquidity pools will receive "allocation points," and OSMO rewards will be distributed proportionally based on the points of each mining pool.

Fortunately, for mining pools without internal incentives, OSMO tokens are not the only rewards. External incentive providers, such as users trading in the pool, can allocate their rewards independently. Similar to internal liquidity incentives, external providers can choose which variables to set, such as the time required to qualify for rewards or the amount of rewards.

Exit Fees

If binding liquidity metrics are the "carrot" for long-term liquidity, then exit fees are the "stick." When LPs withdraw funds from the liquidity pool, the protocol charges a small fee in the form of LP tokens.

This exit fee is determined by the pool creator and is intended to benefit the remaining contributors to the pool, as the exit fees are burned. Overall, when LPs decide to withdraw their liquidity, they will reclaim their initial funds plus accrued trading fees minus exit fees and impermanent loss.

Impact

It is noteworthy that Osmosis is the first DEX in the Cosmos ecosystem to support IBC. Although there are now other DEXs, such as Gravity DEX and Injective Protocol, Osmosis is the first application chain based on Cosmos to achieve significant IBC trading volume. Due to its first-mover advantage, Osmosis continues to rank first in IBC trading volume and second in total trading volume, only behind Terra.

The growing market interest in the Cosmos ecosystem has also brought attention to Osmosis. Since its launch, total trading volume and total locked value have been on the rise. In fact, both metrics have reached all-time highs in the past 30 days. Given past rumors that interacting with Osmosis or holding OSMO tokens could qualify one for airdrops of project tokens in the Cosmos ecosystem, there are no immediate signs of this trend slowing down.

Protocol Features

Customizable Liquidity Pools

Much of the inspiration behind Osmosis comes from the Ethereum-based DEX Balancer and its ability to provide multi-asset liquidity pools. The Osmosis Labs team views mixing assets into liquidity pools as the first of many customizable options. With this level of customization, the role of the DEX evolves from merely trading spot price assets to being able to support options markets, inter-chain staking, and more.

Osmosis liquidity pools offer flexible market-making functionalities. Unlike Uniswap's constant product, Balancer's constant mean, or Curve's mixing functions, Osmosis's function is variable, thus achieving the goal of becoming an "AMM laboratory."

The DEX encourages liquidity providers to experiment with different market-making functionalities. Osmosis can incentivize more experimentation, and new variations can ultimately lead to innovative solutions to reduce slippage or impermanent loss.

Pool parameters, including trading costs, initial token weights, and time-weighted average price calculations, are set by the original creators of the pool. However, all Osmosis liquidity pools are governed autonomously by LP token holders.

Voting rights are allocated based on the weighted ownership of funds in the pool, with longer lock-up periods increasing voting power. As Osmosis anticipates that the market will determine the best capital efficiency, autonomous pools are just one factor in establishing the most competitive liquidity pools, with the ultimate game being a highly competitive market that offers greater participation for capital allocators.

Superfluid Staking

Compared to rollup-centric ecosystems like Ethereum, multichain ecosystems like Cosmos face challenges in security. Therefore, security becomes crucial for public chains in the Cosmos ecosystem.

Osmosis has designed a clever solution to this problem: Superfluid staking, considered one of the biggest advancements in liquid staking since PoS, allows LPs to provide liquidity with their native OSMO tokens while simultaneously securing the underlying network with the same tokens. Below is a visual representation of the Osmosis Superfluid staking platform.

The Superfluid staking model disrupts existing liquid staking solutions. Superfluid staking does not provide liquidity for bound assets but rather takes the liquidity bound from assets and injects it into the network. The fact that assets are already bound to local liquidity pools only helps simplify the balance between security and economic liquidity for the network.

Whitelisted liquidity pools are the only pools eligible to participate in Superfluid staking. This is because Osmosis aims to limit malicious actors from minting risky assets that could then deplete the underlying OSMO token's collateral liquidity pool. Preventing this scenario is crucial for robust security, and determining whether whitelisted pools are eligible will be decided by Osmosis governance.

The benefits of Superfluid staking should be evident: it allows LPs to secure the network through earnings generated from trading fees and rewards from staking, effectively doubling their returns.

At the same time, the underlying network benefits from additional security, creating a win-win situation for all parties involved. More excitingly, Osmosis does not necessarily have to be the only beneficiary; the protocol can offer staking as a service to help other application chains achieve security. The ultimate result is that this Superfluid staking feature supports a secure network interwoven into a large cross-chain network.

Integration of CosmWasm

At the beginning of March, Osmosis announced that it had successfully partnered with blockchain development tool company Confio to integrate the CosmWasm cross-chain smart contract engine into the Osmosis protocol. Through this collaboration, Osmosis has access to an untapped resource pool, as CosmWasm boasts one of the largest developer ecosystems outside of Ethereum and Solana.

CosmWasm provides a WebAssembly virtual machine (WASM) for developers familiar with Go and Rust. Developers can build new permissionless smart contracts that can run across multiple Cosmos SDK blockchains using a toolkit. We can view this as a framework designed to enhance the smart contract capabilities for interoperability among various Cosmos application chains.

Additionally, the collaboration may hint at other features that Osmosis could support in the future, such as yield aggregators, liquidity management tools, and more. While this is exciting news for those looking to maximize yields, the Osmosis Labs team has made it clear that its ultimate goal is to maintain an interoperable DEX-centric protocol.

Anti-MEV

Osmosis's upcoming roadmap includes addressing Maximum Extractable Value (MEV), one of the biggest challenges in decentralized trading. Since all transactions occur on the blockchain, they can be accessed on a public ledger, allowing miners to rearrange the order of transactions within their blocks for profit.

In cases where prior approval of transactions is crucial, such as front-running or acquiring valuable NFTs, miners will have an advantage over ordinary users. This type of MEV behavior is detrimental to DEX users while benefiting users like miners who determine the transactions within blocks.

MEV initially started as a privacy issue and later evolved into an economic issue. According to data from MEV Explore, miners have extracted over $600 million on Ethereum alone since January 2020.

Osmosis's solution to MEV is to implement a form of encryption known as threshold encryption.

The threshold encryption process begins before transactions enter the mempool. Encrypted transactions hide transaction details from validators, preventing them from determining which transactions to prioritize. Only after the transaction is completed and executed can validators see the details. Note that during this process, only the transaction details are encrypted; the fee amounts will remain public. As a result, unprocessed transactions continue to be added to the blockchain in order of fee amounts.

OSMO Token Economics

As the native governance token, OSMO supports all functionalities of the Osmosis application chain. A maximum supply of 100 million tokens will be set for daily epoch-based issuance. The release schedule is similar to Bitcoin's famous "halving," with Osmosis reducing the number of new tokens by one-third each year. New tokens will be distributed through staking rewards, developer allocations, community pool distributions, and liquidity mining incentives. The complete supply curve is shown in the figure below:

The release of OSMO tokens is a fair distribution, spread among airdrop recipients and the protocol's strategic reserves. Notably, 50% of the supply was airdropped to ATOM holders, while the remaining 50% was reserved for strategic reserves to support the ongoing development of the protocol. Reserve tokens can be used to fund open-source projects, make investments, or provide grants.

Conclusion

The competition for DEX trading volume is fierce, but ultimately, successful applications must continuously innovate to attract liquidity providers. The Osmosis community believes that this trading platform is well-positioned to capture significant liquidity and protocol revenue due to its status as a multichain core, the flexibility to set liquidity pool parameters, innovations in staking models, and an exciting anti-MEV roadmap. Only time will tell how successful it will be— but early indicators look promising.