One of the foremost interesting recent developments in cryptocurrency is that the emergence of decentralized liquidity pools.
Algorithmic-based smart contract liquidity pools like Ethereum’s Uniswap, or privacy-focused, off-chain decentralized exchanges like Starkware’s StarkDEX are just two samples of projects leading the charge.
Inbound/outbound liquidity is important for the creation and growth of monetary markets. Price discovery, and therefore the ability to maneuver in and out of trade positions, whether they’re from an enormous institutional firm, or a small-time trader, remains key if crypto is to succeed in maturity; where its aggregate daily volume could sustain at levels like the legacy economic system.
It is not exactly a secret that the blockchain and cryptocurrency industries have a liquidity problem. Large trades altogether but the foremost popular assets move the market to an alarming degree. This volatility then causes a cascade of ills.
First, it decreases the credibility of the markets thanks to the truth or appearance of manipulation.
Second, it makes people nervous about holding assets, meaning that applications hooked in to low volatility have trouble getting off the bottom.
Third, it harms the viability of decentralized exchanges and other decentralized token economies because insofar as they depend upon slow mainnets, they lag badly behind the worth information available on faster, more efficient centralized exchanges.
Decentralized payments are only one piece of the puzzle of what it really means to be decentralized, as you’ll also need the help of decentralized liquidity to create and extend additional functional financial layers on top of your blockchain-related protocol/application. Liquidity is king, and it can make or break your protocol if you can’t rally sufficient liquidity to assist in your project’s growth and enable the utilization cases you sought bent provide your end-users.
With the proliferation of decentralized lending, borrowing, and more, the present decentralized landscape appears to be grasping the essential essentials necessary for the financial instruments we’ve grown conversant in in traditional legacy markets (Compound Finance is but one example). to raised understand where we’re at, let’s first go deeper into what solutions the industry has concocted so far.
To begin, liquidity pools could help address a key problem faced by new token-based projects: the necessity to arduously bootstrap a liquidity-providing network before the project has real utility. Liquidity pools can mitigate this by providing a singular, less-speculative reason for people to carry tokens that don’t have an outsized user base yet (i.e., to supply liquidity for a fee).
Moreover, the existence of decentralized liquidity pools provides added reassurance to large investors in young projects who don’t want to urge stuck trying to unload their tokens in an illiquid market. The pools thus function somewhat like insurance for token holders (we’ll cover this concept more below).
Second, liquidity pools should be considered a powerful achievement in decentralized institution-building. Liquidity has long been a central concern, not just for cryptocurrency and blockchain projects, except for financial markets generally. it’s a prerequisite for the expansion of an entire range of other institutions, financial and otherwise.
And, decentralized liquidity provisioning is emerging through a mechanism that doesn’t exist in traditional financial markets — automated smart contracts. this is often a completely new vector of provisioning liquidity, which exposes the likelihood of broader, more competitive involvement in market-making. Liquidity pools are thus a bellwether of maturation for decentralized cryptocurrency markets.
The total quantity of liquidity in these decentralized pools remains small by the standards of conventional markets (which can trade daily with volumes exceeding many billions in USD), but it’s growing at a reasonably impressive pace.
Here is an accounting of the entire USD value locked in Uniswap contracts, from https://defipulse.com/uniswap:
The total USD value locked in Uniswap contracts, from https://defipulse.com/uniswap.
It is also worth taking a better check out a couple of of the leading liquidity pool providers. Their mechanics vary, and aren’t always terribly straightforward. However, they represent important opportunities for investors to research. And if they still grow, they might alter calculus for giant investors curious about cryptocurrency markets but concerned about liquidity risks.
Uniswap has emerged as a pacesetter within the decentralized liquidity space. Their contracts are simply pools of fifty ETH and 50% some target asset. Traders buy either asset directly from the contract, causing the costs to maneuver algorithmically. When differences emerge between the algorithmically-determined price offered by the contract and therefore the market value, arbitrageurs close the gap. Anyone can replenish liquidity within the contracts by contributing an equal amount of ETH and therefore the target asset. Doing so entitles them to a pro-rata share of the trading fees (0.3% per trade) that accumulate within the contract.
This piece provides a superb starting framework for understanding the essential bet implied by supplying liquidity to a Uniswap contract. A deeper dive are often found here also.
Bancor built the primary meaningful decentralized liquidity solution. However, it’s been losing ground because it suffers from several technical disadvantages, and is additionally hooked in to its own token (making its solution less elegant than Uniswap’s architecture).
The biggest problem faced by liquidity suppliers to pools like Uniswap is that the risk of major relative price movements between the paired assets; if the worth of an asset during a trading pair surged suddenly, it could cause a ripple effect of negative counter-trades from a scarcity of proper liquidity. it’s therefore ideal to provide liquidity in terms of a stable asset, rather than a volatile one like ETH. This problem is exacerbated by Bancor’s dependence on its native token, BNT, which is even less stable/liquid than ETH, while also adding the complexity of another abstracted token to take care of.
Moreover, transactions on Bancor are structured in such how that they will incur high gas fees, and that they aren’t presently getting to utilize layer 2 scaling technologies to alleviate those pains.
Bancor is functioning to deal with these issues instead by introducing a replacement stablecoin to exchange BNT because the basis of its liquidity pools, also as a couple of other upgrades. It remains to be seen whether the trouble will succeed. it might appear though that an algorithmic approach like Uniswap, paired with a tightly-coupled asset like ETH or another ETH-built stablecoin, is perhaps the simplest approach until further improvements emerge within the industry.
[Other projects like Kyber Network and therefore the 0x Project specialise in cross-chain liquidity and possess their own ERC20 asset — but they fall outside the scope of this post.]
Balancer is merely a whitepaper for now. But it details a protocol that might allow people to simply instantiate new liquidity pools, backed by larger, more flexible sets of assets, with more precisely calibrated algorithmic incentives and user-determined transactions. If it flies, it could encourage much broader participation in providing liquidity.
Described during a recent whitepaper, the Convexity Protocol may end up to be a crucial accelerant of decentralized liquidity provision. By allowing anyone to simply write collateralized options contracts, and sell those contracts within the sort of an ERC20 token (oTokens), it’ll allow more sophisticated sorts of hedging to occur without an intermediating institution. While the Convexity Protocol could have an almost infinite range of possible uses, one among the foremost obvious is as liquidity insurance. Would-be liquidity providers in new markets will have a touch less to fear once they can use relatively stable assets as their nucleotide, insuring against collapses within the liquidity of their target market.
Obviously, there’s no gift. during a sense, it’s possible to consider Convexity Protocol as “spreading” risk from riskier markets into more stable ones. Nonetheless, if the basics of participation still improve, tools like this might speed the arrival of meaningful decentralized liquidity during a wider range of assets.
Unipig and StarkDEX
It is important to note the connection between liquidity and network capacity/throughput. the lack of the most Ethereum chain to rapidly settle high volumes of transactions may be a fundamental impediment to liquidity providers, because the power to quickly remove liquidity may be a driver of willingness to supply liquidity within the first place. (For a deeper dive into the nuances of this dynamic, take a glance at the CFTC’s report about the 2010 “Flash Crash”).
Therefore, one among the foremost important fronts within the battle to unlock decentralized liquidity is that the development of Layer-2 and off-chain solutions for the rapid settlement of a high volume of trades. Two of the foremost interesting projects during this space are Unipig and StarkDEX. They both promise vastly increased network capacity and execution time, but take different routes to urge there.
Unipig, currently sleep in demo form, allows transactions to be posted in real time and high volume to aggregators running fully functional Uniswap contracts, which are then “rolled up” and posted to the most chain. Parties’ trust within the veracity of those aggregators’ reporting is backed by a bond that dishonest aggregators stand to lose. this is often an easy scaling solution whose success with real money at stake will depend on effective auditing of aggregators. We suspect that the Unipig team will get the auditing and verification mechanisms right, but there’s still some uncertainty about whether large institutional players will ever feel comfortable supplying liquidity through this channel. Still, we expect their approach of scaling Uniswap via layer 2 technologies and optimistic roll-ups remains one among the foremost adept approaches yet seen; without the utilization of SNARKs/STARKs, more developers are going to be ready to find out how to utilize their setup more quickly.
StarkDEX, on the opposite hand, uses state-of-the-art cryptographic STARK proofs to require on-chain transactions, process them off-chain, then batch them back on-chain so as to extend throughput. The challenges of this method are purely technical, instead of social, like Unipig (where you only need to get others to provide more liquidity over time). Running on testnet it appears to extend transaction volumes by quite 100x versus the most chain, with correspondingly decreased gas costs.
It is not obvious to us how the trade timing constraints it imposes will interact with the requirements of major liquidity providers, or how quickly their solution are going to be adopted by other major players. That said, it’s a really promising step towards orders-of-magnitude better throughput and major new opportunities for decentralized liquidity provision, and will likely play a pivotal role within the creation of scalable dark pools — with few or no trust assumptions
The Liquidity backbone
Plenty of parties have tried (and will still try) to “shortcut” the liquidity problem by providing liquidity from some concentrated or centralized venue. But this only highlights the deep connection between liquidity and therefore the decentralization ethos itself.
Any economic system is, during a sense, only as decentralized because the sources of its liquidity. After all, if there are not any central banks, but instead a couple of whales acting as central banks, what exactly has improved?
When provided from a good range of parties whose behavior is deeply uncorrelated, liquidity is fundamentally more robust: it’s less likely to evaporate during a crisis and more indicative of a healthy market.
Therefore the health of DeFi is essentially just like the health of decentralized liquidity venues. We are excited to ascertain numerous great teams attacking this key problem and striving to unlock a replacement phase of maturity and innovation within the space.