A Brief History of Liquidity
For most of the history of cryptocurrencies, assets were only tradable through a
centralized broker
or directly peer-to-peer. Decentralized exchanges emerged in the late 2010s but were
inefficient, centralized, and had poor liquidity.
In late 2018, Uniswap V1, the first true Automated Market Maker(AMM), premiered.
Liquidity pools
Uniswap introduced decentralized liquidity
pools. "Liquidity providers" or "LPs", could deposit
their assets into two-sided liquidity pools to provide liquidity for ERC-20/ETH
pairs and earn
trading fees. This process was later expanded to ERC-20/ERC-20 pairs on Uniswap V2. Uniswap's
architecture kept swaps fast and efficient for traders.
Note
Since then Uniswap's AMM model has become the dominant decentralized exchange model.
Numerous forks and
variations of Uniswap V2 have also emerged since then.
Incentivizing liquidity providers
Another process that emerged was protocols incentivizing liquidity providers with rewards to
increase liquidity in pools. This is known by many names, including yield farming, liquidity
mining, or mercenary capital. Liquidity mining was extremely profitable and helped grow DeFi
exponentially in 2020.
Conclusion
However, a long-term problem emerged during this growth period. Uniswap was not as efficient as
it could be. It lacked capital efficiency. Liquidity could only be provided full-range, meaning
that liquidity providers (LPs) had to provide liquidity far outside the ranges of the current
price of the assets. All LPs chose the same position. The only variable was how much they put
in.
Effects on the market
This relatively simple change had dramatic effects on the market. Liquidity pools became much
more efficient. Fees could only be earned by those who provided liquidity within the proper
ranges. Although LPs could still offer full-range positions, they became less competitive. The
liquidity concentration and range began to adjust in real-time to match the needed liquidity for
any pool. A dynamic new market emerged in the world of liquidity.
Algebra Finance
In addition to Uniswap V3, a new generation of decentralized exchanges and concentrated
liquidity models were built. Algebra
Finance became a major alternative to Uniswap V3 with
innovative features like dynamic fees.
Note
Algebra's growing number of supported exchanges used different token models like Solidly
and a more blockchain-native approach creating deeper liquidity for their users.
BUSL License expired
Uniswap V3's BUSL
License expired on April 1st, 2023. After it expired, established Uniswap V2
forks like PancakeSwap and
SushiSwap immediately adopted concentrated liquidity
Other non-fork exchanges like Balancer and Kyberswap also embraced concentrated liquidity
approaches.
Although there were doubts about the profitability and sustainability of concentrated liquidity,
Decentralized
Exchange Aggregators proved decisive in routing trades to them. Concentrated
liquidity now dominates the decentralized trading space.
Details
It's very important for liquidity providers and protocols to understand that they are now in a
competitive space. Nobody, no matter how skilled at management, is always profitable.
Pools can be oversaturated with liquidity for the amount of volume, which leads to poor fee
performance for the LPs, even in ideal conditions. High volatility can make even the
best-managed pools take losses. A group of users who gets incentives have a huge advantage over
those who don't have them. Full-range positions and sustained four-figure APRs are simply not
going to happen much anymore.
Regardless of whether you're a new solo liquidity provider, a seasoned farmer who rode the DeFi
Summer wave, or a traditional finance market maker, everyone now has to adjust to concentrated
liquidity's pros and cons.
Optimal State
This represents the optimal condition that the rebalancing strategy endeavors to maintain for an
extended duration. It denotes a scenario where the price fluctuates within the designated range
of concentrated liquidity, facilitating efficient accumulation of deposit tokens via
concentrated trading fees. Within a healthy state, the allocation and concentration of tokens
are as follows
Excessive Inventory State
This condition (and the associated provision of concentrated liquidity) is activated in response
to an excess of deposit tokens. In the over inventory state, the rebalancing strategy adjusts
the vault's positioning to prioritize the sale of deposit tokens, aiming to restore it to a
optimal state. As depicted, a slight increase in the paired token spot FX prompts the
concentrated position to sell a significantly larger quantity of the deposit token compared to a
similar movement in the spot FX in the opposite direction.
Insufficient Inventory State
This condition (along with the associated provision of concentrated liquidity) arises when there
is an insufficient amount of deposit tokens. In the under inventory state, the rebalancing
strategy adjusts the vault's positioning to prioritize the purchase of deposit tokens, aiming to
restore it to a healthy state. As demonstrated, a slight decrease in the paired token spot FX
prompts the concentrated position to buy a significantly larger quantity of the deposit token
compared to a similar movement in the spot FX in the opposite direction.
Exceptional Volatility State
Variances among rapid 5-minute and gradual 60-minute TWAPs, alongside disparities between the
present price and swift TWAP, will serve as indicators for detecting such fluctuations in price.
By default, a 6% variance activates the high volatility state. Within this state, liquidity will
be dispersed across the entire spectrum for both tokens.
Extreme Volatility State
Discrepancies between rapid and gradual TWAPs, along with variations between the current price
and rapid TWAP, will be employed for identifying these price fluctuations. By default, a 25%
deviation initiates the extreme volatility state. Within this state, the strategy will enter a
lockout phase, halting any additional deposits into the vault. It's essential to note that
during this period, the vault remains unbalanced, requiring human intervention to evaluate the
circumstances and determine the appropriate timing and method for rebalancing.
Automated Solutions
In order to enhance the capability for liquidity providers to establish robust on-chain
liquidity, LCM sought an efficient solution to scale their rebalance functionality.
Automating with Chainlink introduces a decentralized service designed specifically for handling
tasks on behalf of smart contracts. This system utilizes decentralized, highly reliable, and
economically incentivized automation nodes to activate smart contracts precisely when they need
to execute critical on-chain functions. These functions typically occur at regular intervals
(e.g., daily at a specific time) or in response to external events (e.g., when an asset reaches
a predefined price).
Key Attributes of Chainlink Automation
1. Decentralized, Reliable, and Efficient Automation — Chainlink Automation ensures swift
transaction identification and confirmation, even in periods of network congestion, utilizing
Chainlink’s proven transaction manager.
2. Cost-Effective, Time-Tested Infrastructure — Leveraging Chainlink Automation allows us to cut
in-house automation infrastructure expenses, decrease DevOps resource allocation, and enhance
overall speed and efficiency.
3. Facilitates Rapid Scaling — Chainlink Automation provides the capability for faster scaling,
circumventing the challenges associated with constructing and maintaining the infrastructure
necessary for reliable automation across multiple chains.
4. Unleashes New Possibilities — Through smart contract automation, we can explore novel use
cases and unlock functionalities that would have otherwise been unattainable.
