Modern decentralized exchanges (DEXs) rely primarily on liquidity providers (LPs) to provide the tokens that are traded. These liquidity providers are rewarded by receiving a portion of the trading fees generated on the DEX. Unfortunately, although liquidity providers earn income through fees, they are exposed to impermanent losses if 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 impermanent loss for liquidity providers.
What is directional liquidity pooling?
Directional Liquidity Pooling is a system developed by Maverick Automated Market Maker (AMM, for its acronym in English). The system allows liquidity providers to monitor how their capital is used based on anticipated 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 rise or fall, the liquidity provider can charge commissions without changing the ratio of your deposited tokens. Nevertheless, if the price of any of the paired assets moved up or down, the liquidity provider would lose money due to what is called impermanent loss. In some cases, these losses may be greater than the commissions obtained from the liquidity pool.
This is one of the main drawbacks of the traditional liquidity pool model, since the liquidity provider cannot change its strategy to make a profit based on rising or falling price movements. So, for example, if a user expects the price of Ether (ETH) to rise, there is no method of making a profit through the liquidity pool system.
Directional liquidity pooling —or Directional liquidity pooling— changes this system to allow liquidity providers to choose a price direction and reap additional benefits if they choose correctly. For example, if a user is bullish on ETH and the price goes up, they will earn additional commissions. Bob Baxley, CTO of Maverick Protocol, told Cointelegraph that:
“With Directional LPing, LPs are no longer limited to betting the sideways market. They can now bet with their LP position that the market will move in a certain direction. By bringing a new degree of freedom to the provision of liquidity Directional LPing MMAs like Maverick AMMs open up the liquidity pool market to a new class of LPs.”
How does this benefit DeFi users?
The MMA industry and related technologies have grown rapidly in recent years. One of the first innovations was UniSwap’s constant product (x * y = k) AMM. But constant product MMAs are not capital efficient because the capital of each LP is spread across all securities from zero to infinity, leaving only a small amount of liquidity at the current price.
This means that even a small trade can have a big effect on the market pricecausing the trader to lose money and the LP to pay less.
To solve this problem, various plans have been drawn up to “concentrate liquidity” around a certain price. Curve did the AMM stableswap, and all the liquidity in the pool is centered around a single price, which is usually equal to one. Meanwhile, Uniswap v3 made range MMA more popular. This gives limited liability partners greater control over where their cash goes by allowing them to bet on a range of prices.
Rank MMAs have given LPs much more freedom in allocating their liquidity. If the current price is within the chosen range, the capital efficiency can be much better than constant product AMMs. Of course, how much the stakes can raise depends on how much the LP can stake.
Due to the concentration of liquidity, the capital of the LP is better to generate commissions and exchangers or swappers obtain a much better price.
A big problem with range positions is that their efficiency drops to zero if the price moves out of the range.. So, to summarize, it is possible that a “set it and forget it” liquidity pool in a Range AMM like Uniswap v3 could be even less efficient in the long run than a constant product LP position.
Therefore, liquidity providers need to keep changing their range as the price moves to make a Range AMM work better. This requires work and technical knowledge to write the integrations of the contracts and gas rates.
Directional liquidity pooling allows liquidity providers to bet on a range and choose how liquidity should move as price moves. Plus, AMM’s smart contract automatically changes liquidity with every trade or swap, so liquidity providers can keep your money working no matter the price.
Liquidity providers can choose to have the automated market maker move their liquidity based on price changes of their pooled assets. There are four different modes in total:
- static: Like traditional liquidity pools, liquidity does not move.
- On the right: Liquidity moves to the right when the price increases and does not move when the price decreases (bullish expectation on the price movement).
- On the left: Liquidity moves to the left when the price decreases and does not move when the price increases (bearish expectation on the price movement).
- Both of them: Liquidity moves in both price directions.
The liquidity provider can put a single asset and have it move with the price. If the chosen direction matches the price action of the asset, the liquidity provider can earn income from trading fees and avoid impermanent losses..
When the price changes, impermanent loss occurs because the AMM sells the more valuable asset in exchange for the less valuable assetleaving the liquidity provider with a net loss.
For example, if there is ETH and Token B (ERC-20 token) in the pool and ETH increases in price, the AMM will sell some ETH to buy more Token B. Baxley elaborated on this:
“Directional liquidity represents a significant expansion of the options available to prospective LPs in decentralized finance. Current AMM positions are essentially a bet that the market will go sideways – if it doesn’t, an LP is likely to lose more in impermanent losses than he earns in fees. This simple reality prevents many potential LPs from entering the market.”
When it comes to traditional MMAs, it is difficult to protect yourself from impermanent losses as they can be caused by price movement in any direction. Instead, directional liquidity providers can limit their exposure to impermanent losses with unilateral pooling. Unilateral pooling means that the liquidity provider only deposits one asset, so that if an impermanent loss occurs, it can only occur on that one asset.
Clarification: The information and/or opinions expressed in this article do not necessarily represent the views or editorial line of Cointelegraph. The information set forth herein should not be taken as financial advice or investment recommendation. All investment and commercial movement involve risks and it is the responsibility of each person to do their due research before making an investment decision.
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