Although revolutionary, DeFi’s core financial concepts draw from traditional high finance. Once you understand the role of market makers, you will understand the significance of liquidity pools, liquidity providers, and yield farming.
In the previous article, you have learned what Decentralized Finance (DeFi) is and how it relates to yield farming. More importantly, you have seen how easy it is to start yield farming within a couple of minutes, by connecting your MetaMask wallet to any of the DeFi protocols you see on the ranking and tracking website, such as DeFi pulse.
As you have noticed, a critical part of the process to start earning passive income via yield farming is to add your funds to a liquidity pool. Therefore, by becoming a liquidity provider, depending on your pool share, yield farming becomes possible. This makes liquidity pools and liquidity providers critical cogs of the entire DeFi ecosystem. To better explain how these vital components work, let’s compare them to traditional, centralized systems.
Centralized Liquidity Providers
If DeFi hadn’t existed at all, that doesn’t mean there would be no liquidity providers. The foremost market in which they come into play is the forex — foreign currency exchange market — with participants ranging from individuals to various institutions and banks. The total sum traded on forex daily is estimated to be around $6.6 trillion, every hour of the day except for weekends.
Next to forex lies the stock market with its regional exchanges, New York Stock Exchange (NYSE) being the largest one. According to the World Federation of Exchanges, the daily volume on stock exchanges is around $165 billion.
(Source: World Federation of Exchanges, CC BY-4.0)
When you think about these massive trading volumes on a mechanistic level, two problems arise:
- How to ensure price stability?
- How to ensure that traders can buy and sell assets at any price level?
A liquidity provider is an answer to both of those concerns. In a centralized system such as the stock market and forex, liquidity providers act as market makers. This means they act on two levels:
- As a buyer.
- As a seller.
Accordingly, this makes liquidity providers market makers. In turn, liquidity providers can make a profit on the bid-ask spread. Simplified, the stock market is an assortment of sellers and buyers — traders. When they want to buy an asset, they bid for it, and when they want to sell an asset, they ask for a bid.
In turn, a bid-ask spread represents the amount by which the ask price is higher than the bid price. Circling back to market makers, bid-ask spreads allow them to make profits while they provide a valuable service. In fact, you have almost certainly found yourself in need of a market maker or a liquidity provider.
For example, let’s say you want to sell your used bicycle, but for some reason, nobody is responding to your ad for many months. A market maker would buy your bicycle but for a lower price. While not ideal, this scenario is better than getting zero cash from it. The question then arises, for how long do you hold onto your asset, in this case, bicycle, in the hopes to sell it for your preferred price?
Likewise, a zero-commission trading app like Robinhood makes money through rebates from market makers like Citadel Securities. In other words, this hedge fund, which serves as a market maker/liquidity provider, pays Robinhood for the right to execute the trades of its customers.
Unfortunately, as we have seen with the case of GameStop, this also means that market makers hold hefty leverage over the trading platforms, which is why Robinhood eventually restricted/delisted up to 50 stocks in the wake of retailer traders short-squeezing the hedge funds like Citadel.
As you can see, in a centralized system, a liquidity provider is essential to facilitate a smooth flow of the market, but it also comes with heavy baggage. Moving on to decentralized liquidity providers, keep in mind the following points:
- Liquidity providers are the same as market makers.
- Market makers, such as hedge funds or exchanges like NYSE, oil the gears of the entire market, so it doesn’t grind to a halt.
The Advantage of DeFi Liquidity Providers
Now that you have a grasp of the traditional high finance, it’s time to see what its upgraded, blockchain-powered version looks like. Simply put, market makers in the DeFi ecosystem are still needed, but are replaced with auto-executive code — smart contracts.
The entire Ethereum blockchain is based on its smart contract programmability. And the majority of the DeFi space is based on the Ethereum blockchain.
- Liquidity pools are smart contracts that supplant the function of centralized exchanges/hedge funds.
- DeFi liquidity providers are users who place their tokens/cryptocurrency into liquidity pools.
- Consequently, liquidity providers gain profit from yield farming — interest rates on locked assets — just like market makers.
Essentially, what needs to be heavily regulated in a centralized system, and is still prone to manipulation, has been completely automated in the DeFi ecosystem. This is best exemplified by decentralized exchanges.
Decentralized exchanges — DEX — are marketplaces where sellers and buyers meet their bids and asks. However, because DEXs rely on there being enough sellers and buyers for any price point, this creates a liquidity problem. In a centralized system, market makers would fill this role, so that all sellers and buyers would have their demands served.
In a DeFi space, this liquidity issue is resolved by liquidity pools — automated, continuous liquidity!
How Liquidity Pool Interacts with Liquidity Providers
For a liquidity pool to happen, we need token pairs. Let’s take Ethereum’s native coin — ETH — and the most popular stablecoin — USDT. Stablecoins are tethers to USD, as a solution to cryptocurrency volatility, so they are equal to the dollar.
1 ETH = 1,300 USDT
When liquidity providers provide the same amount of both ETH and USDT to the ETH-USDT liquidity pool, someone depositing 1 ETH would have to match it with 1,300 USDT. In other words, with the ETH-USDT liquidity pool formed, if a trader wants to turn in ETH for USDT, they can perform this exchange based on deposited tokens. This is obviously a superior solution to wasteful waiting for another trader to come in and meet their demand for USDT.
Moreover, just like market makers in traditional finance, DeFi liquidity providers are incentivized to contribute to liquidity pools. The higher their stake in the pool is, the higher will their yield farming be. Trading fees vary between DeFi protocols. Uniswap offers a 0.3% fee for liquidity providers, which is enough to even offset impermanent loss.
Impermanent loss represents a loss in the value of your deposited tokens, from the time you deposited them into the liquidity pool. Nonetheless, with sufficient trading volume and fees, impermanent loss can still be counteracted, maintaining the incentives for liquidity providers.
If you want to see this in action, please visit the short guide outlined here.