The evolution of Liquidity provision right before our eyes.
The future of Defi coming, but will we recognize it?
Transaction fees, Yield Farming, AMM, PMM and Atomic Swaps, the future of crypto gets closer and closer, but it may not be the future we think is coming. If your new to decentralized finance you can read my introduction to DeFi article Here and then come back.
AMM or Automated Market Maker and Liquidity Provision…transaction fees
Being a Liquidity provider means investing your capitol, as in depositing dollar equivalent amounts of a trading pair, and agreeing to buy and sell both assets to traders on the exchange. You do this to earn transaction fees.
It started out as the straight forward adoption of the role of market maker, you pick an asset pair you think will be in demand to trade. Or you create a need to trade and then create a liquidity pair to fulfill this newly created need to trade. Then step back and let the transaction fees roll in…
Or so we thought. Funny thing this Market Maker stuff, it involves risk of the loss of your capitol from Impermanent Loss or market downturns or both. While many articles and YouTube videos have been produced and bright people debate whether it’s a bug or a feature. All I know is that I have lost money due to it and I am not alone. As previously stated, depending on the market you can lose money or make money, or both.
While straight AMM Liquidity Provision is popular, the risk of loss of capitol, or actual loss of capitol must be exceeded by transaction fees to be profitable to investors. And for multiple trading pairs it wasn’t and so Liquidity providing evolved.
Yield farms were developed, I think of them as an evolutionary step. The investor or liquidity provider does the same first step: providing dollar equivalent pairs on decentralized exchanges. But instead of transaction fees in the exchange blockchain token like Ethereum or BNB? You earn Yield Farm specific tokens. So on PanCakeSwap, based on Binance Smartchain blockchain, you don’t earn the blockchain token BNB, you earn the project token Cake. This is different from the AMM decentralized exchange like Uniswap on the Ethereum blockchain, where you earn Ether.
This change was an improvement over a straight AMM in terms of increased yield, but it’s profitability is dependent on high project token prices. And project tokens on yield farms usually start out high and fall lower. There were various reasons selected to blame for falling token value and subsequent modifications in Yield Farming are meant to reduce losses and improve gains.
Cross Project Yield Farming
This change is a feature of older yield farms like Autofarm. The Yield Farm project places it’s project token in a liquidity pair on another project, earning both the other project token and the second project token. This is a creative way to increase yield to your project investors by giving them two yield sources for the same pair. It also can reduce selling pressure on the second project token and increase its price. These two changes increase earnings for investors providing capitol to trading pairs. There is still potential capitol loss from impermanent loss and token price decline, but these new modifications increase earnings enough and often cause token price appreciation, so losses are reduced and investor profits increase.
PMM Proactive Market Maker
As you recall I described AMM or Automated Market Maker as the software code underlying Uniswap, the first? Automated Market Maker Decentralized Exchange, which launched the liquidity provider DeFi revolution. This started as transaction fees only, then single project Yield Farming and led to cross project/dual project yield farming, and now we have an evolution of AMM called PMM or Proactive Market Maker. This new AMM algorithm was created to eliminate Impermanent Loss. It is new, so I can not verify that it works, but this would be a welcome change. It would be truly remarkable and an evolutionary jump in AMM DEX exchanges development.
Lastly and still in development is atomic swaps and Thorchain AMM
Thorchain is building a DEX or decentralized exchange, which is described as a modified AMM which reduces net losses to liquidity providers by charging traders additional fees, which are paid to liquidity providers. This is more of an additional compensatory mechanism then an evolutionary one, but it still represents change away from the old code to the new code, so I think it can still be considered evolutionary. The last part about Thorchain, which is still in the works, are called Atomic Swaps where you trade directly from your wallet, instead of transferring tokens to a centralized exchange wallet like Binance or Coinbase. This was a radical and important change when we used primarily CEXs or centralized exchanges for trading,but it is less important now that we have Dexs or decentralized exchanges and use Metamask to carry our cryptocurrency and control them at all times with our private keys. So Atomic swaps are less revolutionary and are a useful innovation for a prior period in time.
This last item is an important example of how the future may not be what we expect. We expected Atomic Swaps to free us from the need to surrender our cryptocurrency to centralized exchanges to trade cryptocurrency and make profits. But now we don’t just make money buying and selling, we make money with DeFi and we don’t deposit our crypto on exchanges for DeFi we connect our wallets to DeFi project websites. So by using cold wallets and web wallets like Metamask, we already have greater control over our tokens without Atomic wallets. The future we once envisioned is here, and it looks different from what we thought it would look like, and I think that’s a good thing.
Do you understand the evolution of DeFi?
What do you think of impermanent loss?
Do you have questions?
Shortsegments is a writer focused on cryptocurrency, the blockchain, non-fungible digital tokens or NFTs, and decentralized finance.
Read more of shortsegments articles here: https://leofinance.io/@shortsegments
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