Decentralized finance (“DeFi”) is an emerging system that combines decentralized exchanges with token liquidity pools. These smart contracts coordinate investors who want to earn a return on their tokens while facilitating efficient trading of those assets without the need for centralization or trusted third parties like banks and brokers.
In traditional exchanges, an order book model works well when there are enough buyers and sellers in the market. But as cryptocurrency trading becomes more popular. Much like in traditional finance, a lack of liquidity in a particular cryptocurrency can lead to unpredictable price swings. That is, one large transactions can cause high volatility. Therefore, tokens lacking sufficient liquidity are unlikely to be adopted because it is difficult to buy & sell them
To create a functional order book with Ethereum’s present throughput and block time, vital characteristics like low latency are sacrificed. With every interaction costing gas fees in addition to the lack of scalability, market makers would go out of business quickly when updating their orders. This is why the crypto powers-that-be invented something new that could work well within this decentralized space: liquidity pools!
In its most basic form, a liquidity pool contains two tokens and each pool creates a new market for that particular pair of tokens. WBTC/ETH is an example of one popular liquidity pool on Uniswap.
When a new pool is created, the first liquidity provider sets the initial price of its assets. The incentive for this person to provide an equal value in tokens remains throughout other providers who join later on. If there’s a difference between global market prices and those within pools, instant arbitrage opportunities arise which can lead to loss of capital from each individual providing funds into said pool
When liquidity is supplied to a pool, the liquidity provider (“LP”) receives special tokens called LP tokens in proportion to the amount of liquidity it has supplied. When trades occur and commissions are distributed among all token holders, if they want their supply back plus accumulated fees they must burn their LP tokens.
In the Uniswap example, a 0.3% fee is charged from every trade and distributed to all liquidity providers in proportion to how much they’ve contributed towards making the pool possible. If you want your share of fees back plus what was already taken out, you must burn your LP tokens.
The algorithm that calculates the price of exchange tokens is called an Automated Market Maker (AMM). This mechanism can be found in different liquidity pools, but each pool uses a slightly different model.
Basic liquidity pools, such as those used by Uniswap, use a constant product market maker algorithm that ensures the product of their supplied tokens is always the same. Furthermore, due to this algorithm they can provide liquidity regardless of trade size and ensure it will be there for future trades. This happens because no matter how much people want or don’t need in total; supply increases with demand which makes price increase automatically so users trust its stability while trading off-chain making them more likely to hold on token instead sell at lower prices than waiting hours/days until next refill opportunity occurs again (when possible).
The main idea is that the proportion of tokens in a pool dictates price. For example, if someone buys ETH from a WBTC/ETH pool, they reduce the supply of ETH and add to token supply for WBTC resulting in an increase in the price of ETH and decrease in the price of WBTC.
The price movement is dependent on the size of a trade compared to the pool’s capacity. The larger this ratio, i.e., smaller trades with respect to large pools are conducted, then less slippage will occur and vice versa.
Because larger liquidity pools create better trading experiences, some systems started incentivizing liquidity providers with extra tokens for supplying to certain pools. This process is called “liquidity mining” which is another topic for another time.
A former professional rugby player, Adam S. Tracy brings over twenty years’ experience as an attorney, consultant and dealmaker with a particular focus on cryptocurrency, digital products, payments and immersive corporate structures. As an accomplished executive and advisor to high risk merchants and stakeholders, Adam has proven himself as a results oriented, decisive leader with proven success advising early market entrants, technology adapters, as well as established participants across a wide range of verticals. Adam Tracy’s attack-first personality allows him to excel in dynamic, demanding environments including complex corporate negotiations, distressed environments and regulatory investigations.
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