If you got into crypto in late 2020, then the DE-FI buzzword is surly ringing in your ears, and you’re probably sick and tired of it.
The term is a bit of a misnomer and a catch-all phrase for taking legacy financial products and putting a token somewhere in the mix, and hey, that’s De-Fi in a nutshell. We can all go home now.
We can talk about the various types of De-Fi from staking, flash loans and collateral providers. Still, I want to focus on the one that seems to be the most popular, and that is liquidity providing for decentralised exchanges (DEX’s).
I think it was first started with Bancor on ETH, but it was really Uniswap that took the idea, run with it and turned it into a more crypto mainstream tool.
Why is LP so popular?
Centralized exchanges have always been a love-hate product in crypto! We need on-ramps into the system and a place with reasonable liquidity to supply the market, and early miners used their liquidity to do that.
Eventually, venture capital came in, started mining operations or purchased a lot of coins and spun up exchanges. While exchanges have improved in recent years, there is still the obvious central point of failure, and the Mt Gox wounds are firmly engrained in early Bitcoiners.
The idea of not your keys, not your Cryptos, continues to this day and from it came the solution of DEX’s. Decentralized exchanges that allow you to trade but still have ownership of your keys.
The issue with early DEX’s was that they didn’t have the liquidity to provide for trading pairs, and the project dragged on through altruism until liquidity pools took over with the help of smart contracts.
Liquidity pools a market solution
Liquidity pools allow traders who have coins but don’t feel like trading them; they can provide them to exchanges to fill orders!
As you supply coins into a big pool, it allows those wanting to trade to make orders without running out of supply.
In exchange for borrowing your coins, liquidity pools provide incentives like fees on trades.
This is a simple explanation for how this works and how each market participant benefits from the system.
As you can probably tell, the more liquidity, the bigger the orders that can go through them each day!
The more orders, the more fees, the more fees, the more providers want to get in and get some of those fees and reduce the gains.
Liquidity pools are still in their infancy, and there are so many options that can be included depending on the goals of that exchange or ecosystem.
Flat Fee pools
I think this would be the basic structure of a liquidity pool incentive would be the flat structure. The fees collected for the day exchanging assets that leverage this pool would be distributed across the various providers depending on their contribution to the pool.
Tiered fee pools
Adding a little game theory to it, you could have a tiered approach where if you maintain a certain percentage of the pool, you get a preferred return. This encourages larger holders to remain in the pool.
A burn pool could take some of the day's fees, and instead of rewarding all of it to the providers, some of it can be burned to reduce inflation of the tokens and squeeze supply.
Liquidity pools are often set in a pair, so you would provide an equal amount in, let's say, US dollar value on each side of the trade.
In a multi-asset pool, you could add 1 or several assets to the pool; this works great for stable coins and is something that curve has been using.
For example, you could have HDB, SBD, USDT, DAI and USDC all in one pool.
Hybrid pools could grab a mix of different structures, like having a burn component and a tiered fee pool.
These are just a few of the ideas I've seen pitched, and I am sure there will be more coming soon. I think liquidity pools are going to become a greater part of crypto's next steps into adoption.
Have your say
What do you good people of HIVE think?
So have at it, my Jessies! If you don't have something to comment, "I am a Jessie."
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