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 the trading fees generated on the DEX. Unfortunately, while liquidity providers generate income through fees, they are subject to volatile losses as the price of their deposited assets changes.
Directional Liquidity Pooling is a new method that differs from the traditional system used by DEXs and aims to reduce the risk of volatile losses for liquidity providers.
What is directed liquidity pooling?
Directional Liquidity Pooling is a system developed by Maverick Automated Market Maker (AMM). The system allows liquidity providers to control how their capital is used based on predicted price changes.
In the traditional liquidity pool model, liquidity providers are betting on the price of their asset pairs moving sideways. As long as the price of the asset pair does not rise or fall, the liquidity provider can charge fees without changing the ratio of its deposited tokens. However, if the price of any of the paired assets were to move up or down, the liquidity provider would lose money due to what is known as a temporary loss. In some cases, these losses can be greater than the fees earned from the liquidity pool.
This is a major disadvantage of the traditional liquidity pool model as the liquidity provider cannot change their strategy to profit based on bullish or bearish price action. For example, if a user expects the price of Ether (ETH) to go up, there is no method to make a profit through the liquidity pool system.
Directional Liquidity Pooling changes this system by allowing liquidity providers to choose price direction and earn additional returns if they make the right choice. For example, if a user is bullish on ETH and the price goes up, they will receive additional fees. Bob Baxley, Maverick Protocol’s chief technology officer, told Cointelegraph:
“With directional LPing, LPs are no longer tied to the sideways market bet. Now you can bet your LP position on the market moving in a certain direction. By bringing a new level of freedom to liquidity delivery, directional LPing AMMs like Maverick AMM are opening up the liquidity pool market to a new class of LPs.”
How does this benefit users in DeFi?
The AMM industry and related technologies have grown rapidly in recent years. A very early innovation was UniSwap’s constant product (x * y = k) AMM. However, constant product AMMs are not capital efficient because the capital of each LP is spread across all values from zero to infinity, leaving only a small amount of liquidity at the current price.
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This means that even a small trade can have a large impact on the market price, causing the trader to lose money and the LP to pay less.
To solve this problem, several plans were made to “concentrate” the “liquidity” around a certain price. Curve made the stableswap AMM, and all of the liquidity in the pool is concentrated at a single price, which is often equal to one. Meanwhile, Uniswap v3 popularized the Range AMM. This gives limited partners more control over where their liquidity goes by using a range of prices.
Range AMMs have given LPs a lot more freedom when it comes to allocating their money. When the current price is included in the chosen range, capital efficiency can be much better than constant product AMMs. Of course, how much the stakes can go up depends on how much the LP can bet.
Due to the concentration of liquidity, LP capital is better at generating fees and swappers get much better prices.
A big problem with range positions is that their efficiency drops to zero when the price moves outside the range. 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 range as price moves in order for a range AMM to work better. This requires work and technical knowledge to write contract integrations and gas fees.
With directional liquidity pooling, liquidity providers can set a range and choose how the liquidity should move when price moves. Additionally, the AMM smart contract automatically changes liquidity on every swap, allowing liquidity providers to keep their money flowing regardless of the price.
Liquidity providers can choose to have the automated market maker move their liquidity based on the price changes of their pooled assets. There are four different modes in total:
- Static: As with traditional liquidity pools, liquidity does not move.
- Right: Liquidity moves to the right when price rises and does not move when price falls (bullish expectation of price movement).
- Left: Liquidity moves to the left when price falls and does not move when price rises (bearish expectation of price action).
- Both: Liquidity moves in both price directions.
The liquidity provider can set up a single asset and have it move with the price. When the direction chosen is consistent with the asset’s price action, the liquidity provider can generate income from trading fees while avoiding temporary losses.
When the price changes, a temporary loss occurs as the AMM sells the more valuable asset in exchange for the less valuable asset, causing the liquidity provider to incur a net loss.
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For example, if ETH and Token B (ERC-20 token) are in the pool and ETH increases in price, the AMM will sell some ETH to buy more Token B. Baxley expanded on this:
“Directional liquidity represents a significant expansion of the options available to potential LPs in decentralized finance. Current AMM positions are essentially a bet that the market will go sideways; If this is not the case, an LP is likely to lose more in temporary losses than it earns in fees. This simple reality is arguably preventing many potential LPs from ever hitting the market.”
With traditional AMMs, it is difficult to hedge against temporary losses as they can be caused by price movements in any direction. On the other hand, directional liquidity providers can limit their exposure to volatile losses through unilateral pooling. With one-way pooling, the liquidity provider deposits only one asset, so a temporary loss can only occur on that single asset.
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