Osmosis (OSMO) is a decentralized exchange (DEX) and automated market maker (AMM) protocol for the Cosmos ecosystem.^[1] Osmosis is a multi-chain AMM built for the Cosmos ecosystem. It offers interoperability between blockchains using Inter-blockchain Communication Protocol (IBC) and Axelar. Osmosis is powered by OSMO token. ^[7]

History

Osmosis is an AMM protocol by Osmosis Labs created using the Cosmos SDK. The project was announced in October 2020 and launched on June 19, 2021. Its development was led by Sunny Aggarwal, Josh Lee, and Dev Ojha. Osmosis raised $21M in an October 2021 token sale led by Paradigm.^[6]

Osmosis Labs Pte. Ltd. ( “Osmosis Labs” ) is responsible for most of the initial code development for the Osmosis protocol, and the Osmosis project is run by a decentralized validator set. Every upgrade and modification to the protocol is voted on and carried out by the Osmosis community (holders of the OSMO governance token.)^[2]

Overview

Osmosis is an AMM protocol for interchain assets that aims to allow the development and management of a self-balancing, noncustodial, interchain token index. It is a decentralized exchange platform for swapping, earning, and building on the Cosmos network. Osmosis uses smart contracts to determine the price of digital assets, to produce liquidity via a peer-to-peer (P2P) methodology, and to exact trades between users. It offers tools for analyzing assets and liquidity, governance participation, and building interchain-native apps. Osmosis seeks to offer customizability, such as adjustments of swap fees, custom-curve AMMs, and multi-token liquidity pools. ^[1][3]

Osmosis also offers non-IBC assets bridged from the Ethereum and Polkadot ecosystems. As an appchain DEX, Osmosis has greater control over the full blockchain stack than DEXs that must follow the code of a parent chain. This fine-grained control has enabled the development of Superfluid Staking, an improvement to Proof-of-Stake security. Superfluid staking allows the underlying OSMO in a liquidity pool to add to chain security and earn staking rewards. The customizability of appchains also allows for the development of a transaction mempool shielded with threshold encryption, which will significantly reduce harmful MEV on Osmosis. MEV, or Miner Extractable Value, refers to the total potential value that miners can acquire by rearranging, adding, or omitting transactions within a block.^[4][5][12]

Architecture

Osmosis is an automated market maker (AMM) protocol designed to facilitate the creation of customized AMMs featuring independent liquidity pools. Developed on the Cosmos SDK, Osmosis employs Inter-Blockchain Communication (IBC) to facilitate cross-chain transactions. ^[13]

Automated Market Makers (AMM)

Automated market makers (AMMs) are decentralized finance protocols that facilitate asset swapping without relying on a central intermediary. Smart contracts replace traditional trading desks and order books to execute trades. Liquidity pools, created by users who deposit assets into them, enable transactions. These users, known as liquidity providers (LPs), can create pools for any asset in a permissionless manner. In Osmosis, pool creators have the flexibility to customize transaction fees and exit fees, which liquidity providers pay when withdrawing assets from the pool. ^[14]

Token Weights

Liquidity pools are collections of tokens with predetermined weights, where each token's weight indicates its proportion of the total value within the pool. For instance, Uniswap pools typically have two tokens with equal 50-50 weights, ensuring parity between the total values of the assets. However, other weight distributions, such as 90-10, are also possible, and liquidity pools may contain more than two assets. ^[15]

In Osmosis, pool creators have the freedom to select the tokens and their corresponding weights within the pool. Once established, these parameters cannot be altered. However, other users retain the ability to create separate pools with different configurations. ^[15]

Pricing

Fixed token weights enable automated market makers (AMMs) to establish deterministic pricing. Within liquidity pools, tokens maintain their weights, representing their value relative to each other, even as the quantity of tokens in the pool fluctuates. Consequently, prices adapt to ensure that the relative value between tokens remains consistent. ^[16]

Market Maker Functions

AMMs use a mathematical formula to determine asset pricing within the pool. A constant function ensures that trading rules remain consistent regardless of the trade size or the asset being traded. The most common type is the Constant Product Market Maker, but other functions are also utilized. ^[17]

LP Tokens

When users deposit assets into a liquidity pool, they receive LP tokens, which represent their ownership stake in the pool. For instance, if a user deposits OSMO and ATOM tokens into Pool #1, they receive Pool1 share tokens in return. These share tokens indicate the user's proportional ownership of the pool. ^[18]

When users withdraw their liquidity from the pool, they receive back a percentage of the total liquidity equivalent to their LP tokens. However, due to the changing quantities of assets resulting from buying and selling within the pool, users are unlikely to withdraw the same amount of each token they initially deposited. Typically, they receive more of one token and less of another, depending on the trades conducted within the pool. ^[18]

Liquidity Mining

Liquidity mining, also known as yield farming, involves users earning tokens by providing liquidity to a DeFi protocol. This mechanism helps offset the impermanent loss experienced by LPs and provides an additional incentive alongside transaction fees. Liquidity mining rewards are especially valuable for new protocols, as they bootstrap initial liquidity, encourage greater usage, and generate more fees for LPs. ^[19]

Impermanent Loss

Liquidity providers earn revenue through fees and special pool rewards. However, they also face the risk of impermanent loss, where they might have been better off holding assets instead of providing them. Impermanent loss refers to the difference in net worth between holding assets and providing liquidity. Liquidity mining initiatives aim to offset impermanent loss for LPs. ^[20]

When asset prices within the pool change at different rates, LPs may end up holding larger amounts of the asset that experienced a lesser price increase (or a greater price decrease). For example, in the OSMO-ATOM pool, if the price of OSMO increases significantly relative to ATOM, LPs may end up with larger portions of the less valuable asset (ATOM). ^[20]

Long-Term Liquidity

Liquidity mining rewards can attract short-term participants known as "mercenary farmers," who swiftly deposit and withdraw their liquidity to maximize their returns. These participants are primarily interested in the speculative value of governance tokens and often switch between protocols to chase the highest yields. ^[21]

While mercenary farmers may initially boost protocol activity, their departure can lead to significant liquidity fluctuations, causing challenges for users when executing trades due to slippage. Therefore, maintaining long-term liquidity is crucial for the success of an automated market maker (AMM). ^[21]

Osmosis incorporates two mechanisms to encourage long-term liquidity: exit fees and bonded liquidity gauges. ^[21]

Inter-blockchain communication protocol (IBC)

The inter-blockchain communication protocol (IBC) facilitates communication between independent blockchains by defining a set of structures that can be implemented by any distributed ledger meeting specific criteria. ^[22]

IBC enables various cross-chain applications, such as token transfers, swaps, multi-chain contracts, and data sharding. Initially, Osmosis utilizes IBC primarily for token transfers. However, Osmosis plans to integrate additional features enabled by IBC as it evolves. ^[22]

OSMO Token

OSMO is the native token of the Osmosis network. The OSMO token is a governance token that allows staked token holders to decide the future of the protocol. OSMO is primarily used for voting on protocol upgrades, setting the swap fee for the base network, and allocating the mining rewards for liquidity pools.^[1]

OSMO token holder governance aims to select the liquidity pools eligible for rewards, allowing stakeholders to draw up an incentivization strategy that benefits the long-term interests of the protocol. Osmosis also aims to let third parties add incentive mechanisms to some liquidity pools. ^[5][7]

The maximum number of OSMO tokens has been set at 1 billion. OSMO also seeks to be used to deploy new curves with the help of existing wallet integrations, order flow, IBC connections, and liquidity in the Osmosis ecosystem. ^[6]

Tokenomics

OSMO is the governance token for the protocol, with a set total supply of 1 billion. During the genesis, 100 million OSMO tokens were initially distributed, divided equally between airdrop recipients and a strategic reserve. Token issuance takes place at the end of each daily epoch, following a "thirdening" schedule, which involves reducing token issuance three times a year. In the first year, 300 million OSMO tokens were released, followed by 200 million in the second year, 133 million in the third year, and so forth. ^[8]

The distribution of newly released tokens is as follows:

\

• Staking Rewards: 25%
  \
• Developer Vesting: 25%
  \
• Liquidity Mining Incentives: 45%
  \
• Community Pool: 5%

The overall token distribution is the following:

\

• Liquidity Reward Mining: 40.5%
  \
• Developer Vesting: 22.5%
  \
• Staking Reward: 22.5%
  \
• Community Pool: 4.5%
  \
• Strategic Reserve: 5%
  \
• Airdrop: 5%

Use Cases

The use cases of the OSMO token are the following: ^[9]

• Voting: Active network stakeholders propose, evaluate, and approve protocol upgrades. OSMO governance participants presently select pools eligible for liquidity rewards, enabling stakeholders to devise an incentivization strategy aligned with the protocol's long-term interests.
• Transaction Fees: Users must pay transaction fees for posting transactions on the chain, with the fee amount determined by the computation and storage costs of the transaction. The minimum gas costs are set by the proposer of the block containing the transaction. The transaction fees collected are distributed among OSMO stakers on the network. Validators have the discretion to choose which assets they accept as fees in the blocks they propose, and all accepted assets are converted to OSMO before distribution.
• ProtoRev: The ProtoRev module mints and burns OSMO tokens to facilitate arbitrage transactions on-chain, ensuring balanced prices across liquidity sources within the chain.
• Taker Fees: Osmosis imposes a modest taker fee on all trades, initially set at 0.1%. The Protocol Fee Controller subDAO manages reductions or exemptions for specific routes. Taker fees are collected in the Quote asset of the trade. OSMO collected is distributed to stakers, while non-OSMO fees are divided, with 33% allocated to the Community Pool and the remaining 67% converted to OSMO before distribution to stakers.
• Superfluid Staking: Superfluid Staking contributes to the security of the consensus layer through a mechanism resembling "Proof of Useful Stake." Participants receive OSMO based on the value of their stake in liquidity pool tokens, which are both staked and delegated to validators. This connection aligns the security of the consensus layer with GAMM LP shares. Superfluid Staking is applicable in pools that include OSMO in the pairing and have activated this feature through governance decisions.

Osmocon

Osmocon is a yearly event hosted by Osmosis that showcases speakers, announcements, and various events associated with Osmosis. The 2023 edition occurred on July 21st in Paris, France. Speakers included Sunny Aggarwal, Josh Lee, Idris Olubisi, Dev Ohja, Paul Erlanger, among others. ^[10]

The 2022 edition took place on June 9th in Austin, Texas. Participants included Membrane Protocol and Andromeda Protocol, with panelists such as 0xBrainJar, Composable Finance, Matt Bell, Nomic, Sergey Gorbunov, among others. ^[11]