Yesterday, we wrote about the role of automated market makers in the success of DeFi in 2020. But how do you get users to provide their own liquidity? Without liquidity, the liquidity pools cannot fill. In order to persuade users, there has to be something in return. Because without the liquidity of users, decentralised exchanges cannot scale up.
In order to scale automated market makers (AMM) such as Uniswap, liquidity mining was devised. Before liquidity mining, it was a slow process to build up liquidity within DeFi protocols. Many potential capital providers considered the risky returns they could obtain in DeFi to be insufficient. It just wasn’t worth running so much risk for what you get in return.
Liquidity mining adds a nice reward for early investors, by distributing tokens that gave network governance rights to the contributors of capital. Those governance rights often include the possibility to take market place fees out of the protocol, which makes the tokens scarce.
Deposits into liquidity pools increased significantly, and decentralised exchanges such as Uniswap turned into money machines. This solves the problem of DeFi markets starting from a cold start, i.e. without any form of liquidity.
Dynamic automated market makers
Yesterday we wrote that Uniswap is proof that SMP works, and above you read that liquidity mining can scale up SMP. But the AMMs of Uniswap are not without problems. They are capital-intensive, because they need a balance of two tokens. Also, high market volatility creates an imbalance between SMPs and regular spot market prices, causing liquidity providers to lose money to arbitrage traders. Certainly less liquid Uniswap pairs (compared to, for example, Binance) fall prey to this.
Competitors in 2021
Balancer, Curve and Bancor are working on various solutions to these problems. Balancer is working on a constant product market maker. This means that several assets can draw from the same liquidity pool. So suppose you have ten Ethereum pairs, then you no longer need ten separate liquidity pools, but could combine them.
Bancor launched the second version of their SMP, using data oracles to dynamically balance the liquidity pools. This only happens if market prices deviate too much from spot market prices. Bancor itself says that this can improve capital efficiency by a factor of 20.
Curve tackles it differently. The SMP of Curve mainly consists of equal trading pairs. As a result, slippage is minimal. An example of such a trading pair is Tether-DAI, both stablecoins worth 1 dollar. Now you might think, what does the market gain from swapping stablecoins? As a liquidity provider (of several stablecoins) you can get between 10% and 50% interest and you get a part of the transaction costs (on which you also get interest). In addition, there is no ‚impermanent loss‘. If you provide liquidity for non-stablecoin pools, you must take into account the market value of the liquidity you provide.
It is expected that Uniswap will continue to dominate the DeFi exchanges in 2021. It is also expected that the popularity of decentralised exchanges will only increase and that Uniswap can become a top 10 exchange. Much depends on the user-friendliness of decentralised exchanges and how they deal with high transaction costs. These are inevitable in a bull run.
By 2020, the fixed dollar value in smart contracts will have risen from USD 600 000 to more than USD 16 billion. If next year DeFi gets part of the same hype as ICOs in 2017, it is easy to predict that this is just the beginning.