Learn more about the concept behind liquidity pools and check out the review of today's top 5 DeFi liquidity pool providers.
Learn more about the concept behind liquidity pools and check out the review of today’s top 5 DeFi liquidity pool providers.
Decentralized finance (DeFi) is currently the new gold-rush in cryptocurrency as the blockchain-backed project is attracting millions of people worldwide. Liquidity pools are an essential aspect in DeFi as they are an upgrade on the order book model used by most Decentralized Exchanges (DEXs) in the past. There are different liquidity pools across other protocols such as Uniswap, Balancer, and Curve, and we’ll be looking at the top 5 liquidity pool providers in DeFi.
Before we begin, you may want to understand liquidity pools and the concept behind the project.
The term liquidity pool refers to a pool of tokens that are locked in a smart contract of a DeFi protocol. Liquidity pools facilitate trading by supplying liquidity and it is adopted by many decentralized exchanges (DEXs) like Uniswap, Curve, etc. Switzerland-based Bancor Protocol was the first to use a liquidity pool, but they became widely popularized by Uniswap.
Liquidity pool is an upgrade on the order book model used by standard exchanges like Coinbase. This order book model is also applied in traditional exchanges like NYSE and NASDAQ.
In the order book model, demand meets supply to initiate an order; naturally, buyers would want to maximize profit by purchasing the asset for the lowest price obtainable want to buy an asset for the lowest price obtainable, likewise, the seller would try to sell that particular asset for the highest price possible. For the trade to take place, both parties have to agree on the price of that asset. When this is not achieved, the trade is at risk of falling through. In this case, market makers are introduced.
Market makers are simply traders that are always readily available to purchase or sell a particular asset, to facilitate trading. They act as the go-to-guys for buyers and sellers so both parties do not necessarily need the other before buying or selling. This model is brilliant but has been found to encounter difficulties when applying it in DeFi; the process is too slow, relatively more expensive, and may result in poor user experience. This is because the order book model entirely relies on market makers. The makers usually monitor the current price of an asset by continually changing their prices, which results in a vast number of orders clogging the system and, in some cases, lead to order cancellations. This is where the liquidity pool comes into play.
The first user to provide liquidity to the new pool has the liberty to set the opening price of the assets in the pool and is encouraged by the platform to provide the same amount of both tokens to the pool. When this is achieved, the liquidity provider is then rewarded with a special token known as (Liquidity Provider) LP token, which is equivalent to the amount of liquidity they supplied to the pool. A 0.3% fee gotten from the execution of trade is then distributed amongst all liquidity providers in the pool.
After the successful facilitation of a trade by the liquidity pool, the price of the token pairs is automatically adjusted by smart contracts called Automated Market Maker (AMM).
As a result, the ratio of the tokens in the liquidity pool decides the price of the token sale. For instance, if a trader buys ETH from a USDT/ETH pool, to increase the price of ETH, the trader decreases the supply of ETH and increase the supply of USDT. As a result of this, the price of ETH appreciates which causes a reduction in the price of USDT. The price movement is proportional to the trade size, which is proportional to the pool’s size.
Some of the advantages of Liquidity pools in DeFi are:
Now that we understand the concept behind liquidity pools let’s check out the top 5 DeFi liquidity pool providers.
Uniswap is a decentralized exchange that supports a smart contract of equal ETH/ERC-20 token pairing. It means that Uniswap allows you to exchange ETH for any other ERC-20 token automatically and in a decentralized manner.
It operates an open-source exchange that allows you to create a new exchange pair in a new liquidity pool for any token and no listing cost. However, the platform charges a transactional fee of 0.3% proportionally distributed among the liquidity providers.
Similar to other top liquidity pools providers, when you supply cryptocurrency to the liquidity pool, you will receive a Uniswap token (UNI) in exchange for providing liquidity. Meaning if, for example, you deposit DAI into the liquidity pool, you will receive a proportional amount of Uniswap (UNI) token in return.
The New York-based liquidity pool provider has some distinct qualities from its rivals. It utilizes the Product Market Model (PMM) mechanism to list prices. Instead of using the order of the buyer and seller in the transaction to calculate the value of the token, the PMM utilizes arbitrary constants in an equation, given as x * y = k.
In the equation, x and y represent the units of the tokens available for exchange on the Uniswap platform, while k is regarded as a constant in the equation. The rate at which the tokens are traded is a significant factor in determining the price value of each unit of the token in the pool. For instance, if you want to purchase OmiseGO (OMG) with Ethereum, OMG’s availability reduces while the availability of ETH increases, leading to OMG attaining a higher market value, in turn, initiating a transaction in a liquidity pool. This means that only when there’s an exchange or a swap will the value of tokens be altered.
Launched in January 2020, Curve is an exchange liquidity pool that is powered by the Ethereum blockchain network, designed to facilitate real-time trading between cryptos of equal value. Curve claims to offer a high-interest rate for investors who provide cryptocurrencies to its liquidity pool. It offers users low slippage because the stable coin is not volatile. The service possesses seven different pools. Four of those pools (Y, Compound, BUSD, and PAX) are lending pools; this means that users can earn money from trading and lending. Two of those pools (sBTC and sUSD) offer incentives on trade transactions, and two are token-based pools (REN and sBTC).
Executing trades while making use of this Curve Finance generally has low risks because of one transaction mechanism.
Despite being relatively new in the DeFi space, Curve Finance is positioned to becoming one of the leading platforms in the DeFi space. Therefore, limiting one’s investments is advisable as the service and token are relatively new.
Balancer Finance was founded by Mike McDonald and Fernando Martinelli in September 2019. The Balancer platform utilizes automatic market maker (AMM) protocol which is also adopted by a number of liquidity provider platforms.
Balancer possesses more than $11 million worth of tokens supplied into its liquidity pools and like in all DEXs, these pools will be used to facilitate trades, thus providing liquidity to traders. They are two main sub-divisions of Balancer pools they are:
Controlled/Private Pools: These are also referred to as exclusive pools; they are created for private individuals who prefer not to use the shared pools the platform provides. These private pools usually have investors who supply large quantities of tokens into the pool.
Finalized/Shared Pools: These pools are accessible to all investors on the platform. They can’t be amended and have a fixed system of operations, unlike controlled pools, and are typically open to the general public.
Asides from the two types of pools mentioned above, Balancer also provides smart pools including stablecoin pools and Liquidity Bootstrapping Pools.
The Switzerland-based decentralized exchange platform was founded in 2016, and it is built on Ethereum blockchain technology. Bancor utilizes the algorithmic market making (AMM) to perform autonomous peer-to-contract token trades and, in turn, generates transactional fees (0.1 – 0.5%) for each trade.
Bancor’s liquidity pool is referred to as Bancor Relay, and users of this platform can receive a share of a pool’s transactional fees by simply adding liquidity to the pool. They will also receive the platform’s pool token (ETHBNT). These Pool tokens symbolize ownership stakes in liquidity pools. This means that when a user adds liquidity to a Bancor pool, they will receive pool tokens proportional to the number of assets added to the pool.
There are three ways you can increase the value of your pool token; the first is the trading fees generated by the pool during trades, incentives programs for the liquidity providers provided by Bancor, pool rewards given by the Bancor platform.
Another feature of Bancor relay is the introduction of stablecoin (USDB) in the event of liquidity volatility due to the effects of the over-dependence of its native token (BNT).
Kyber is an Ethereum-powered on-chain liquidity platform founded in 2017 by Loi Luu, Victor Tran, and Yaron Velner. The protocol enables other DApps to contribute to its liquidity pool, to create an integrated system that enables decentralized atomic token swaps to be possible everywhere. This gives vendors the liberty to accept payment for services in multiple tokens on their platforms, and the tokens can be converted to their preferred token, giving users who are not token holders of the vendor’s choice of token the opportunity to use their tokens for transactions. Its native token is called KNC.
Kyber Network is community-based as KNC owners have the liberty to dictate the number of network fees to serve as a reward to liquidity pool providers proportionally. They also have a significant say on the application of important parameters within the platform.
Liquidity pools are evidence of the dynamism of decentralized finance over the years. Liquidity has always been an integral part of the crypto ecosystem, and DEXs are looking for innovative ways to increase liquidity. It is advised to have extensive knowledge about liquidity pool providers and their features to enable you to maximize user experience.