Financial advisors are very familiar with traditional finance and how the industry works. Registered investment advisors are clients of custodian banks such as Fidelity, Schwab and IBRK who have relationships with stock exchanges such as the New York Stock Exchange and Nasdaq.
Individual securities are traded on stock exchanges and portfolios of securities are held with custodians. Corporate clients have login access to the platforms created by custodians and the advisors can manage these assets through the custodian. This is how the traditional financial system has worked for decades.
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Unlike centralized exchanges like the NYSE, DEXs don’t use the order book system that has been used for decades and, frankly, still works well today. The reason DEXs don’t use the tried and tested order book system is because it requires a team of centralized people and technology to function. Instead, DEXs use smart contracts to facilitate trading. The smart contract that governs trading on a DEX is called a liquidity pool.
Read the first and second parts of this series to understand DeFi.
A liquidity pool is simply a pool of locked assets governed by a smart contract (or piece of software code) used by the DEX to trade — often referred to as “swapping” — crypto assets. Liquidity pools are crowdsourced, meaning that the paired assets in the pool are not pledged by a single person or entity. True to crypto’s decentralized and grassroots style, liquidity pools are created from contributions from the crypto community. Liquidity pools can be thought of as a vast pot of paired assets that facilitate exchanges between currencies.
Liquidity pools are managed by Automated Market Makers or AMMs, software code that governs and automates the process of exchanging assets and providing liquidity, and which allows digital assets to be traded on a DEX using the liquidity pool. On platforms with AMMs, users do not trade with another counterparty (think buyers and sellers in the traditional order book system); Instead, they trade against the pool of paired assets.
To understand AMMs, one must understand the mathematical formula that sits at the core of AMM:
In a blog post by Ethereum co-founder Vitalik Buterin, he proposed the AMM formula, and AMM protocols were born shortly after. In the formula, X represents token A, Y represents token B, and k represents a constant balance between the two tokens.
In a liquidity pool of two paired assets, when the price of X increases, the price of Y decreases, and therefore the constant k remains the same. The total pool volume only increases when new assets are pledged to the liquidity pool. This formula regulates the liquidity pool and creates a state of equilibrium between the prices of the tokens. Buying token A increases the price of token A and selling token A decreases the price of token A. The opposite happens with token B in the liquidity pool.
Another component of AMMs is the arbitrage function. These smart contracts are able to compare the prices of paired assets in their own pools to those across the DeFi ecosystem. If the price fluctuates too much, the AMM will incentivize traders to exploit the mispricing in the native liquidity and external pools, and with this incentive the native AMM will regain equilibrium.
Not only do AMMs incentivize traders to agree on cross-pool pricing, but the actual liquidity pools themselves incentivize participants to pledge assets to the pools. Yield farming is a popular way to generate income in the crypto ecosystem and offers token holders an attractive way to earn a return rather than solely relying on price appreciation.
When an individual contributes paired assets to the liquidity pool, they begin generating tokenized rewards. When a user wishes to exchange assets through a pool, the pool charges the user a small fee to facilitate the exchange. This fee is then paid to the people who pledged their assets to the pool. This fee is often paid out as a Liquidity Provider (LP) token.
For example, a user can pledge assets to a liquidity pool on a decentralized exchange like PancakeSwap. The pledgor earns a return on their pledged asset, as determined by the AMM, and in exchange for providing liquidity, the user is paid in CAKE, the native LP token created by PancakeSwap. The user can then sell their LP token for any other token they want.
Yield farming requires caution. New asset pairs with very low liquidity often incentivize individuals to contribute to the pool by offering a very high rate of return. Often these pairs and pools are new, and users are at increased risk of becoming victims of fraud or theft. Most of the new pools offer malicious actors an attractive way to perform an exit scam called “rug pull”. This is a scam where project creators collect tokens from the community and then abandon the project without returning the tokens.
Another form of risk is called impermanent loss, which mainly occurs during periods of high volatility, which is quite common in cryptocurrencies. If the price of one token in a pool moves significantly relative to the price of the other tokens and liquidity providers decide to withdraw assets from the pool, the people who pledged assets may end up with less than their original contribution. If the liquidity provider chooses to keep assets in the pool, it is possible that given enough time and a decrease in volatility, the liquidity value will rebalance.
So how is an advisor supposed to navigate this whole new system of asset swapping, decentralization and yield farming and the risks that come with it? It is important to know that the traditional financial system is not going away anytime soon. However, the blockchain technology powering DeFi is extremely attractive to both users and providers in the financial industry.
Advisors need to understand how this technology works and be prepared to see the DeFi industry grow over the next few years. The efficiency and cost improvements are attractive to consumers and will enhance the user experience for our customers.
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