DeFi is an extraordinary word used and seen everywhere in the crypto sphere lately. We know it means “Decentralized Finance”, but do we really understand it? This month for SuperBots, we are launching a new series of articles entitled: Don’t defy DeFi. The goal? It’s to go a step beyond the surface knowledge of DeFi concepts, which will then allow you to make your decisions in a thoughtful way, avoiding missteps. Today, we are going to look at a pillar of the DeFi ecosystem, the liquidity pools.
Classic and centralized finance
Before diving into the heart of the matter, it is necessary to know how it works on centralized exchange platforms such as Binance and on classic stock exchanges such as New York Stock Exchange or NASDAQ. On these platforms, trading is done under the order book model. The way it works is quite simple if Investor A wants to sell Asset X at 110 and Investor B wants to buy it at 90, they will have to make concessions and converge the price towards 100. As you can imagine, if it really happened like that, liquidity on the world’s stock exchanges would be anemic. This is where the market makers come in. As you know, for a transaction to be carried out, a counterparty is needed. In the example above, the buyer will only find a counterparty if he agrees to pay more for the asset, and the reverse is true for the seller. Market makers ensure the liquidity of security by being ready to buy and sell at any price, thus offering a permanent counterparty to any investor deciding to buy or sell a security. They are usually paid by exchanges or centralized trading platforms.
A kick in the pants
Of course, and even if there are often several market makers for the same title, it remains very centralized. So we have a centralized system on a centralized exchange platform, that’s a lot for all the crypto-ideologists that we are, isn’t it? DeFi reverses this paradigm by removing the need for a centralized exchange platform, allowing you to keep the sovereignty of your funds, basically leaving them in your wallet. Decentralized exchange platforms could use the order book model, it is theoretically feasible but it would be relatively expensive and slow. Remember that the main cryptos only reach a relatively low number of transactions per second, approximately 30 for ETH in its current version.
The need for a liquidity pool
For a decentralized exchange to work, we still need liquidity and this is where liquidity pools come into play. Investors wishing to trade on an exchange platform such as Uniswap also need a counterparty, which will be provided by the liquidity provider by means of an “Automated Market Maker” algorithm. Concretely and in a simplified way, a liquidity pool is created with two tokens, for example, ETH and USDC, and they must have the same weight in the pool. If there are 10 ETH in the liquidity pool, there must be its equivalent in USDT, which is $30300 at today’s price, making a total of $60600. The liquidity provider chooses to store their ETH and USDT in this pool and receives a transaction fee in return. This allows anyone to automatically play the role of the market maker.
Only advantages then?
On some liquidity pools, commissions compound which makes them very interesting as a source of passive income. But all this is not without risk. As long as the price of the asset, in this case, ETH/USDC, remains more or less stable, you can recover the commissions without too much risk. If ETH goes up too much, you will be subject to what is called an “impermanent loss”. Very simply, this is the difference between what you would have earned by HOLDing the asset directly rather than placing it in a cash pool. A liquidity provider can therefore lose money if the asset rises too much, a loss of around 25% for a 100% increase in the value of the asset.
The heart of decentralized finance lies in the absence of a third party, which takes commissions in the process. This ecosystem is based on an automatic market-making system, working thanks to the liquidity pool. The liquidity pool encourages the liquidity providers to block their funds in exchange for commissions. It sounds simple but it is not without risks, always do your own research before jumping blindly into a new project. Next week we will discuss another important topic in DeFi, the wallet!