Matthew Prewitt is a cryptoeconomic advisor at Amentum Capital and co-lead of the RadicalxChange. Steven McKie is the CEO of Amentum Capital. The views expressed are those of the authors.
One of the most interesting recent developments in cryptocurrency is the emergence of decentralized liquidity pools.
Algorithmic-based smart contract liquidity pools such as Ethereum’s Uniswap, or privacy-focused, off-chain decentralized exchanges such as Starkware’s StarkDEX are just two examples of projects leading the charge.
Inbound/outbound liquidity is essential for the creation and growth of financial markets. Price discovery, and the ability to move in and out of trade positions, whether they’re from a big institutional firm, or a small-time trader, remains key if crypto is to reach maturity; where its aggregate daily volume could sustain at levels comparable to the legacy financial system.
It is not exactly a secret that the blockchain and cryptocurrency industries have a liquidity problem. Large trades in all but the most 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 due to the reality or appearance of manipulation.
Second, it makes people nervous about holding assets, meaning that applications dependent on low volatility have trouble getting off the ground.
Third, it harms the viability of decentralized exchanges and other decentralized token economies because insofar as they depend on slow mainnets, they lag badly behind the price information available on faster, more efficient centralized exchanges.
Decentralized payments are just one piece of the puzzle of what it really means to be decentralized, as you’ll also need the assistance of decentralized liquidity to build 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 cannot rally sufficient liquidity to aid in your project’s growth and enable the use cases you sought out to provide your end-users.
With the proliferation of decentralized lending, borrowing, and more, the current decentralized landscape appears to be grasping the basic essentials necessary for the financial instruments we’ve grown familiar with in traditional legacy markets (Compound Finance is but one example). To better understand where we’re at, let’s first go deeper into what solutions the industry has concocted thus far.
To begin, liquidity pools could help address a key problem faced by new token-based projects: the need to arduously bootstrap a liquidity-providing network before the project has real utility. Liquidity pools can mitigate this by providing a unique, less-speculative reason for people to hold tokens that do not have a large user base yet (i.e., to provide liquidity for a fee).
Moreover, the existence of decentralized liquidity pools provides added reassurance to large investors in young projects who do not want to get stuck trying to unload their tokens in an illiquid market. The pools thus function somewhat like insurance for token holders (we’ll cover this idea more below).
Second, liquidity pools should be considered an impressive achievement in decentralized institution-building. Liquidity has long been a central concern, not only for cryptocurrency and blockchain projects, but for financial markets in general. It is a prerequisite for the growth of a whole range of other institutions, financial and otherwise.
And, decentralized liquidity provisioning is emerging through a mechanism that does not exist in traditional financial markets — automated smart contracts. This is a totally new vector of provisioning liquidity, which opens up the possibility 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 hundreds of billions in USD), but it is growing at a fairly impressive pace.
It is also worth taking a closer look at a few of the leading liquidity pool providers. Their mechanics vary, and are not always terribly straightforward. However, they represent important opportunities for investors to analyze. And if they continue to grow, they could alter the calculus for large investors interested in cryptocurrency markets but concerned about liquidity risks.
Uniswap has emerged as a leader in the decentralized liquidity space. Their contracts are simply pools of 50% ETH and 50% some target asset. Traders buy either asset directly from the contract, causing the prices to move algorithmically. When differences emerge between the algorithmically-determined price offered by the contract and the market price, arbitrageurs close the gap. Anyone can replenish liquid