Modern decentralized exchanges (DEXs) rely primarily on liquidity providers (LP) to provide the traded tokens. These liquidity providers are rewarded by receiving a portion of DEX-generated trading fees. Unfortunately, while liquidity providers earn income through fees, they are subject to irreparable losses if the price of their deposited assets changes.
Directional liquidity pooling is a new method for providing liquidity on decentralized exchanges (DEXs). This method is designed to reduce the risk of impermanent loss, which can occur when the prices of the assets being traded fluctuate.
What is directional liquidity pooling?
Maverick automated market maker (AMM) developed a system called directional liquidity pooling. The system allows liquidity providers to control the use of their capital based on predicted price changes. In the traditional liquidity pool model, liquidity providers bet that the price of their asset pairs will move sideways.
As long as the price of the asset pair does not increase or decrease, the liquidity provider can charge a fee without changing the ratio of their deposited tokens. However, if the price of any of the dual assets is moving up or down, the liquidity provider will lose money due to the so-called non-permanent loss. In some cases, these losses can outweigh the fees earned from the liquidity pool.
This is a major drawback of the traditional liquidity pool model as liquidity providers cannot change their strategies to profit based on bullish or bearish price movements. If a user expects Ether’s price to increase, there is no method to earn profits via the liquidity pool system.
Directional liquidity pooling is a system that allows liquidity providers to choose a price direction and earn additional returns if they choose correctly. If a user is bullish on ETH, that means they think the price will go up. If the price does go up, they’ll earn additional fees. Bob Baxley, the chief technology officer of Maverick Protocol, told Cointelegraph that the company is working on a new protocol that will make it easier for people to use blockchain technology.
How does this benefit users in DeFi?
he AMM industry and related technologies have grown rapidly over the past few years. A very early innovation was the permanent UniSwap (x * y = k) AMM product. However, constant product AMMs are not capital efficient because each LP’s capital is spread over all values from zero to infinity, leaving only a small amount of liquidity at current prices.
This means that even small trades can have a large impact on market prices, traders lose money and LPs pay less.
To solve this problem, several plans were developed to “concentrate liquidity” around a certain price. The Stableswap AMM is a curve pool that is focused around a single price, which is often equal to one. All the liquidity in the pool is centered around this price. In the meantime, the Range AMM (Uniswap v3) became more popular. This gives limited partners more control over where the liquidity goes by allowing them to participate in a range of prices.
Range AMMs have given LPs more freedom when it comes to allocating their funds. If the current price is in your chosen range, the capital efficiency can be much better than a constant product AMM. The amount of money that can be won or lost in a gambling game depends on how much the players are willing to bet.
Because of the liquidity concentration, LP capital is better at generating fees and swaps get much better rates.
A big problem with range positions is that when the price moves outside the range, their efficiency drops to zero. So, in summary, it is possible that a “set it and forget it” liquidity pooling in Range AMM like Uniswap v3 could be even less efficient than a constant product LP position in the long run.
Therefore, liquidity providers need to constantly change their ranges as prices move in order for Range AMMs to work better. This requires work and technical knowledge to write contract integration and gas fees.
Directional liquidity pooling is a process that allows liquidity providers to choose how the liquidity should move as the price moves. This is done by staking a range. In addition, the AMM smart contract automatically changes liquidity on every exchange, so liquidity providers can keep their money working no matter the price.
Liquidity providers can choose to have the automated market maker move liquidity based on the price changes of their aggregated assets. There are four different modes in total:
- Static: As with traditional liquidity pools, liquidity does not move.
- Right: Liquidity moves straight as price rises and stays the same as price falls (bullish expectation of price movement).
- Left: Liquidity moves to the left when the price goes down and does not change when it goes up (bearish expectation of the price movement).
- Both directions: Liquidity moves in both directions of price.
The liquidity provider can set up a single asset and have it move with the price. If the chosen direction matches the asset’s price action, the liquidity provider can earn income from trading fees while avoiding temporary losses.
When the price changes, a non-permanent loss occurs because the AMM sells the most valuable asset against the less valuable asset, leaving the liquidity provider with a net loss.
For example, if there is ETH and Token B (ERC-20 token) in the pool and the price of ETH goes up, the AMM will sell some ETH to buy more Token B. Baxley expands on this:
When it comes to traditional AMMs, a non-permanent loss is difficult to hedge as it can be caused by prices moving in any direction. Directional liquidity providers can protect themselves from impermanent loss by only providing liquidity to one side of a pool. A unilateral pool is where liquidity providers deposit only one asset, so if impermanent losses occur, it can only happen to that single asset.
