Liquidity Pool Research and AMM Comparison
Research done on Liquidity Pool and comparison between various AMMs
Below is an elaboration of the concept of a liquidity pool and a comparison between different liquidity providers (LP) that led us to selecting Uniswap as the LP for this project.
Liquidity Pool and the AMM Protocol
A liquidity pool is a crowdsourced collection (pool) of cryptocurrencies or tokens locked in a smart contract that helps to facilitate trades between different assets on a decentralized exchange (DEX). Decentralized exchanges (DEX) are DeFi platforms that allow the exchange of crypto assets using smart contracts. Unlike traditional centralized crypto exchanges that use order books to match buyers with sellers, smart contracts used in a DEX replace the need for a centralized party using a protocol known as automated market maker (AMM).
The AMM protocol uses a formula that enables the creation of liquidity pools and helps to determine the price of the tokens in the pool. For example, Uniswap, a AMM platform uses the mathematical formula a * b = k for its liquidity pools. While a and b denote the token balance of two respective assets, k always remains constant. Using variations of this market maker protocol formula, Uniswap is able to maintain equilibrium during trading, thus the AMM protocol is critical in ensuring a stable price of the tokens within the liquidity pool.
In essence, the purpose of a liquidity pool is to eliminate the issue of illiquid markets such that traders can freely swap cryptos in an automatic and permissionless manner.
Rewards for Liquidity Providers
Investors who provide liquidity to a liquidity pool are called liquidity providers. When tokens are deposited into a crypto liquidity pool, the platform automatically generates a new token, known as liquidity provider tokens (LPT), that represents the liquidity provider’s proportional share of that pool. These LPT hold the claim to getting back the assets that the liquidity providers deposited. Each time the liquidity pool facilitates a trade, a fractional fee will be distributed to the liquidity providers in the form of LPT. Comparing this scenario to the traditional finance space, it is similar to depositing fiat money to a savings account in a bank and collecting interest on the deposited assets.
Apart from using the LPT within its native DeFi platform, these LPT can also be used in other decentralized finance (DeFi) apps, through a process called yield farming. Yield farming involves the LPT holder depositing their LPT in different DeFi applications to maximize profits. For example, Curve (CRV) token holders can farm these tokens on the Curve protocol using DAI by depositing DAI to Curve’s crypto liquidity pool and receive LPT. They can then deposit received LPT to the Curve staking pool and receive CRV tokens. In this case, the DAI will be earning interest and fees in Curve’s crypto liquidity pool. Concurrently, the LPT earned from the liquidity pool will also earn CRV tokens (farming yield) as a reward for staking. Hence, yield farming using the earned LPT helps the liquidity providers earn both fees and farming yields.
Although this rewards system is a common part of a liquidity provider, our project will not be building a rewards system for now. However, a rewards system can be introduced in the near future.
For the liquidity provider to get back the liquidity they contributed (in addition to accrued fees from their portion), their LP tokens must be destroyed. The liquidity providers can select how much of their total liquidity they would like to withdraw.
Benefits and Limitations of a Liquidity Pool
Benefits
The most apparent advantage of a liquidity pool is that it negates the need for buyer and seller matching since users can simply exchange their tokens and assets using liquidity that is provided by users. This allows for trades to happen with limited slippage even for the most illiquid trading pairs, as long as there is a big enough liquidity pool. The funds held in the liquidity pools are provided by other users who also earn passive income on their deposit through interest and trading fees based on the percentage of the liquidity pool that they provide.
Limitations
A key risk of liquidity pools is that of impermanence loss. This occurs when the price of an investors’ deposited assets changes to be worth less as compared to when they deposited them into a liquidity pool. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit.
Another risk of liquidity pools is the smart contract risks. Once assets have been added to a liquidity pool, they are controlled solely by a smart contract, with no central authority or custodian. As such, if a bug or some kind of vulnerability occurs, the tokens could be lost for good.
Types of liquidity pool / Liquidity pool providers
The following shows a table comparison of the prominent liquidity pools based on a few key metrics (Mechanism, Supported Networks, TVL, Fees/Returns and Unique Selling Proposition) as of December 2022.
Evaluation
Yes, has the second largest TVL after Curve and has more suitable for different types of tokens
No, because better suited for stablecoins and stable assets
No, will prefer the DEX that has the largest TVL
No, will prefer the DEX that has the largest TVL
No, will prefer the DEX that has the largest TVL
Mechanism
DEX with a simple AMM formula.
Allows users to trade ETH for any other ERC-20 token without needing a centralized service. It is an open-source exchange that lets anyone start an exchange pair on the network for free.
DEX for stablecoins.
One major problem with DEXs that use Uniswap's AMM formula is that fees and slippage generated by swapping cryptos aren't ideal for trading between stablecoins and assets pegged to the same value.
Curve altered the AMM formula to make it better for creating stablecoin pools that could be used to trade with low fees and low slippage. Curve also allows for tripool and metapool to be formed which allows three and four assets within each liquidity pool respectively.
DEX for multi-asset pools.
Decentralized platform providing a few pooling options such as private and shared liquidity pools.
DEX with single sided liquidity provision.
Clone of Uniswap but also offers additional opportunities to earn rewards and widens the scope to include liquidity mining, lending and margin trading.
Supported Network
Ethereum, Polygon, Arbitrum, Optimism
Ethereum, Polygon, Arbitrum, Optimism, Avalanche
Ethereum, Polygon, Arbitrum
Ethereum
Ethereum
TVL (as of 19th Dec 2022)
$3.12b
$3.37b
(can be attributed to how Curve holds more stable assets than Uniswap, hence attracting more capital)
$1.37b
$79.54m
$394.58m
Fees received from each trade will be split by liquidity providers proportional to their contribution to liquidity reserves.
Fees/ Returns
V2: 0.3% fee for swapping tokens
V3: 0.01% (v3 governance); 0.05% (stable/stable pairs like USDC/USDT); 0.30% (stable/blue chip pairs like USDC/ETH); 1.00% (wild pairs like ETH/DOGE)
All fees received are paid to liquidity providers
Every trade earns a 0.04% trading fee paid to LPs
Between 0.0001% and 10%
Variable (specific % not mentioned)
SushiSwap offers a 0.3% fee for swaps, 0.25% of which is given to the LP, and the remaining 0.05% is distributed to SUSHI token holders
Unique Selling Proposition
With the launch of Uniswap v3 in mid 2021, v3 aims to provide more flexibility to liquidity providers by allowing almost every parameter to be arbitrarily determined. The hundreds of token options and wide range of liquidity pools further cements its ability to achieve the second highest TVL amongst all DEXs.
Unlike other DEXs such as Uniswap or Bancor, Curve doesn’t maintain the values of different assets to be always proportional to each other. This enables Curve to concentrate liquidity near the ideal price for similarly priced assets, in a 1:1 ratio and have liquidity where it is needed the most. Thus, Curve can achieve a much higher liquidity utilization than otherwise possible with those assets. In addition, this allows Curve to potentially provide the lowest levels of fees, slippage, and impermanent loss of any DEXs on Ethereum.
Balancer V2 enables more than 2 tokens in the same pool, and allows for arbitrary weights to be uneven. It addresses the need of a group of users who want to treat a type of token differently compared to another, by participating in a pool where one token has higher weightage than another.
Bancor v2 allows for a single-sided staking system where liquidity providers can deposit only one token into a liquidity pool.
SushiSwap has a characteristic named “Onsen Program” which is a liquidity provision strategy for new tokens.
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