Sygnum Market View - 4 September 2020
How do decentralised exchanges, a key area of innovation for DeFi, solve the problem of liquidity?
Market makers – how liquidity is created on a traditional exchange
Traditional exchanges such as the NYSE operate on an order book model. An order book is a record of buy (bid) and sell (ask) orders for a security or asset. When there is a convergence of the bid and ask price, orders will be filled by the exchange’s matching engine. Crypto exchanges such as Kraken and Coinbase also operate in this way.
However, there could be occasions where liquidity on either side of the order book is insufficient and buyers and sellers are unwilling to converge on price. That is where market makers can step in. Market makers provide liquidity and are always ready to buy/ sell a security at a certain bid/ ask price. These market makers are typically large banks or specialized financial institutions, and they set prices based on the level of demand and supply in the market. In compensation, they receive the spread between the bid and ask prices and – depending on the incentivisation model of the exchange – a commission for their service.
Automated market makers (AMM)/ liquidity pools – how liquidity is created on a decentralised exchange (DEX)
For DEXs operating on Ethereum, market makers face an obstacle as submitting each order incurs gas costs (transaction fees) to be written on the blockchain and thus accounted for in the order book. Market makers have to constantly adjust their orders to the latest price, and this would be costly for them. Given Ethereum’s relatively low throughput, during times of high network loads the confirmation of transactions require too much time to operate a profitable market making business.
One possible solution to this problem is provided by liquidity pools. Liquidity pools like Uniswap[1], Curve or Balancer are essentially permissionless trading facilities run by automated market making algorithms. In its basic form, a single liquidity pool holds two tokens and each pool creates a new market for that particular pair of tokens. DAI/ETH is a good example of a popular liquidity pool on Uniswap. The first liquidity provider supplies an equal value of both assets and sets an initial price. As parties buy and sell the assets in the pool, it alters the ratio and the price changes to ensure that the value of both remains equal. All this is done automatically through algorithms dubbed as “automated market makers”.
In a liquidity pool price is driven by the ratio of the two assets, and as such the size of a trade in proportion to the size of the pool determines the impact on the price (slippage). Larger pools can therefore accommodate more substantial trade sizes without significant price movement.
Growing popularity of DEXs
Liquidity pools solve a key challenge that traditional DEXs face. In recent weeks, inflow into these pools has far surpassed expectations and the number of transactions on the Ethereum network has skyrocketed (also contributed to by other DeFi projects), with the Uniswap V2 smart contract accounting for 28 percent of all ETH network fees paid in the last 24 hours[2]. This exemplifies that even if liquidity pools require less blockchain transactions to operate, there are still doubts with regards to the scalability of Ethereum-based DEX and DEX-like projects.
[1] Uniswap is a decentralised protocol for automated liquidity provision. [2] As of 2 September 2020
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