Liquidity pools might not be the flashiest aspect of decentralized finance (DeFi), but they are undoubtedly among the most crucial. These pooled funds are the quiet legends of DeFi, enabling decentralized exchanges (DEXs) to operate seamlessly by ensuring there’s always liquidity available for trading.
The impact of liquidity pools on DeFi ecosystems is profound, as they provide the necessary liquidity that enables decentralized exchanges (DEXs) to function efficiently, ensuring that users can trade any token at any time without waiting for a counterparty to match their order.
Not to mention, that these pools are particularly important in volatile markets where rapid changes in asset prices can lead to slippage and impact traders’ returns. The impact of liquidity pools on DeFi ecosystems in such scenarios cannot be overstated.
It’s a system that’s elegant in its simplicity, yet complex in its execution—especially as the DeFi ecosystem grows and platforms like Elys Network introduce innovative approaches that could redefine how liquidity pools function.
The Traditional AMM Model: Solid, Yet Inflexible
Liquidity pools act as reservoirs of assets, pooled by multiple liquidity providers (LPs), to facilitate continuous trading without the need for traditional market makers. At the heart of a liquidity pool are automated market makers (AMMs).
Uniswap and SushiSwap, for instance, use a constant product formula (x * y = k) to maintain liquidity and ensure that there is always a price for every trade. However, this simplicity comes with trade-offs, including the risk of impermanent loss—a phenomenon where LPs might end up with less value after providing liquidity than if they had simply held the assets.
This illustrates the impact of liquidity pools on DeFi ecosystems in terms of risk management.
Recent research from Bancor Network has revealed that over 50% of liquidity providers on Uniswap are losing money due to impermanent loss, even after accounting for the fees they earn. The impact of liquidity pools on DeFi ecosystems here shows the need for innovation.
When asset prices within a pool fluctuate, the fixed ratio can lead to losses, making the AMM model less appealing in volatile markets. Balancer tried to address this with multi-asset pools that allow for customizable weightings, and Curve Finance mitigated risk by focusing on stablecoin pools. These innovations were necessary, but they only scratched the surface of what’s possible.
Now, talking about what’s possible, Elys Network’s approach to liquidity pools is both innovative and tailored to meet the demands of a cross-chain DeFi ecosystem. The network integrates two primary types of liquidity pools — Fixed Weighted Pools and Oracle-Based Dynamic Weighted Pools. Each pool type is designed to optimize different aspects of liquidity provision, asset management, and trading efficiency.
These innovations are tailored to optimize various aspects of liquidity provision, asset management, and trading efficiency, further amplifying the impact of liquidity pools on DeFi ecosystems.
Aspect of Market Dynamics and Price Stability
In a recent interview, DeFi strategist Jake Chervinsky highlighted the importance of balanced liquidity pools in maintaining market stability, especially during periods of high volatility.
Stable and deep liquidity pools contribute to narrower bid-ask spreads, which in turn helps stabilize asset prices. This stability is essential for attracting institutional investors who require predictable market conditions.
Not to mention, institutional investors, such as hedge funds, banks, or large investment firms, typically deal with large volumes of assets. For these investors, market stability and predictable asset prices are crucial.
Elys Network enhances market stability through its Fixed Weighted AMM Pools, which are designed to minimize volatility by maintaining balanced asset ratios. For example, a pool might hold 50% in USDC and 50% in another token, such as ATOM. This pairing with a stable asset like USDC helps dampen the effects of market turbulence, ensuring that the pool remains relatively stable even during significant price fluctuations.
By implementing these fixed ratios, Elys Network ensures that its pools contribute to a more stable and predictable DeFi market, attracting institutional investors who seek consistency and lower risk. This shows the impact of liquidity pools on DeFi ecosystems on a broader scale.
When asked about the most pressing challenges facing the DeFi ecosystem today, and how Elys Network plans to address these challenges, Prashant Srivastava, Co-Founder of Elys Network, said,
I see three major challenges currently facing DeFi: fragmented liquidity, poor UI/UX, and regulatory uncertainty. Elys’ approach includes—
For Fragmented Liquidity: A universal liquidity layer, chain abstraction, and an arbitrage-free pricing model — all designed to offer the best slippage for users. Our unique pool design also aims to reduce impermanent loss to zero.
For User Experience: We’ve introduced CEX-style onboarding, account abstraction, and a variety of products and features to suit all users. Our web and mobile apps are designed to be simple and intuitive.
And For Regulatory Uncertainty: In light of incidents like FTX and Terra, regulatory scrutiny on DeFi has increased, creating barriers and raising operational costs. Elys was built with a strong focus on compliance from the very start. We’ve made sure that our platform operates within legal frameworks globally, ensuring best practices are followed, even amidst regulatory uncertainty.”
Prashant Srivastava, Co-Founder of Elys Network
Aspect of Token Accessibility and Market Depth
Liquidity pools are not just about stability; they are also critical for ensuring the accessibility and availability of tokens across the DeFi space.
In DeFi, market depth refers to the ability of the market to absorb large orders without causing drastic price changes. As we discussed earlier, the impact of liquidity pools on DeFi ecosystems arises in managing these pools during volatile market conditions, where token prices can fluctuate wildly, leading to potential liquidity fragmentation.
Elys Network is a platform that seems to understand that in a constantly shifting market, flexibility isn’t just a nice-to-have—it’s essential.
So, it introduced Oracle-Based Dynamic Weighted Pools, which are exactly what they sound like—pools that adjust asset weights in real time based on external data provided by oracles. This isn’t just an incremental improvement; it’s a significant leap forward in mitigating risks like impermanent loss.
Unlike traditional AMMs that automatically maintain a 50:50 asset ratio using the x*y=kx \times y = kx*y=k function, where price adjustments are driven by market demand and arbitrage opportunities, Elys Network’s pools do not rebalance to a fixed ratio. Instead, the weight of each asset is influenced by oracle prices rather than pure market demand.
This approach allows pool weights to deviate from a fixed distribution, which incentivizes users through weighted breaking fees to adjust the pool by swapping or adding single-sided liquidity. In this system, arbitrage opportunities are accessible to all market participants, not just professional traders with deep liquidity.
Dynamic Weight Adjustment: Adapting to Market Shifts
When an asset like ATOM increases in price, the percentage of ATOM in the pool increases due to its higher value, while the percentage of USDC decreases. The actual amounts of ATOM and USDC in the pool remain unchanged.
To restore the target weight, traders and liquidity providers are incentivized to swap assets or add liquidity, helping to rebalance the pool. This user-driven rebalancing mechanism maintains balance and shields the pool from volatility.
Dynamic Fee Mechanism: Smart Incentives for Stability
Trading fees within these pools aren’t fixed; they vary based on the pool’s balance. Trades that help rebalance the pool—like swapping high-value ATOM for USDC—incur lower fees, while disruptive trades cost more. This encourages actions that maintain equilibrium and incentivizes traders to act in ways that keep the pool stable, benefiting everyone involved. This is a crucial impact of liquidity pools on DeFi ecosystems in terms of market efficiency.
Adding an additional layer of incentive, Elys Network utilizes a Bonus Vault that collects a portion of all swap fees across the platform. This vault is designed to reward users who contribute positively to the liquidity pools by helping maintain balance.
For example, if a trade or liquidity provision moves a pool closer to its target weight, the trader or liquidity provider may receive a bonus reward from the Bonus Vault.
Benefits of Weighted Pools
Weighted liquidity pools, like those within Elys Network, offer several key benefits for liquidity providers and traders in decentralized finance.
Exposure Control
Weighted pools allow liquidity providers to choose their desired exposure to certain assets while still providing liquidity. The weight of each token in the pool determines the level of exposure.
For example, a liquidity provider can create a pool that heavily favors Bitcoin if they expect it to yield bigger gains, or a pool favoring Ethereum if they anticipate it will outperform. This flexibility allows liquidity providers to align their pool composition with their market outlook and investment strategy, using native tokens from all chains through the IBC protocol.
Accurate Asset Pricing
By adjusting the weights of assets dynamically based on market conditions, Elys Network’s weighted pools ensure that asset prices within the pool remain accurate and reflective of current market values. This accuracy is crucial for traders who rely on precise pricing to execute their strategies effectively.
Reduced Impermanent Loss
One of the key advantages of weighted pools is their ability to reduce the risk of impermanent loss.
By allowing traders to adjust asset weights and be incentivized for it, the pools can maintain a more stable balance, minimizing the disparity between the value of assets in the pool and their market value. This approach is particularly beneficial during periods of high volatility, where traditional AMMs might suffer from significant impermanent loss.
Incentivized Arbitrage Opportunities
The dynamic nature of weighted pools creates opportunities for arbitrage that are accessible to all market participants. When the pool’s asset weights deviate from their target ratios, anyone can step in to restore balance, earning profits while contributing to the pool’s stability. This mechanism ensures that the pools remain balanced and liquid, benefiting all users involved.
Improved Liquidity Management
The ability to adjust asset weights within the pool allows Elys Network to manage liquidity more effectively. By increasing the weight of stable assets during volatile market conditions, the network can maintain liquidity without exposing the pool to excessive risk. This is a significant impact of liquidity pools on DeFi ecosystems in enhancing market resilience.
The Value of LP Tokens: Your Share in the Pool
After a certain amount of time, liquidity providers are rewarded with a fraction of fees and incentives, equivalent to the amount of liquidity they supplied, called liquidity provider tokens (LPTs).
These tokens are more than just receipts; they represent a user’s share in the pool and entitle them to a portion of the pool’s assets and any fees generated. LP tokens can then be used in different ways on a DeFi network.
SushiSwap and Uniswap are common DeFi exchanges that use liquidity pools on the Ethereum network containing ERC-20 tokens. At the same time, PancakeSwap uses BEP-20 tokens on the BNB Chain.
The value of LP Tokens fluctuates with the performance of the underlying assets and the trading activity within the pool. If you decide to withdraw your liquidity, you can redeem these tokens for your share of the assets, and the tokens are then burned, reducing the total supply. This is another impact of liquidity pools on DeFi ecosystems in terms of tokenomics.
Incentivizing Liquidity Providers: Balancing Rewards and Risks
The incentive structures offered by platforms like Elys Network are designed to make liquidity provision more attractive. It recognizes that attracting liquidity providers is crucial for maintaining a vibrant DeFi ecosystem. To this end, it offers a dual-token reward system—
- Non-Inflationary Rewards (USDC): When liquidity providers add assets to a pool, they receive LPTs that entitle them to a share of the rewards generated by the pool. In the case of Elys Network, a significant portion of these rewards is distributed in USDC. Since USDC is a stablecoin, this provides liquidity providers with a predictable and stable return, which is directly tied to their LPT holdings.
- Inflationary Rewards (EDEN Tokens): In addition to USDC, Elys Network rewards liquidity providers with EDEN tokens, which are distributed based on the amount of liquidity provided (and thus, the number of LPTs held). These tokens can be staked or vested for further rewards, incentivizing liquidity providers to hold onto their LPTs longer, thereby contributing to the long-term stability of the liquidity pool.
The dual-token system addresses the risks associated with liquidity provision, such as impermanent loss and inflationary pressures. By providing stable USDC rewards alongside EDEN tokens, Elys Network ensures that liquidity providers receive both immediate and long-term incentives, which are all tied to the value and utility of their LPTs.
Practical Strategies for Liquidity Provision
A successful liquidity provision strategy works to ensure that most assets remain liquid, even under precarious economic conditions.
This strategy revolves around striking a balance between risk and return in the financial market. Investors should retain adequate liquidity while simultaneously reaping high returns on their investments. This juxtaposition constitutes one of the many challenges in designing an advantageous liquidity provision strategy.
Elys Network offers multiple strategies for liquidity provision, catering to users with different risk appetites and experience levels—
- Single Asset Provision: This is the simplest method, where users provide a single asset to the pool. While straightforward, this approach may lead to higher fees if the pool needs to rebalance the assets. However, this can be a strategically advantageous method, as it allows users to engage in pool rebalancing at opportune moments, earning weighted breaking fees, which can be a very efficient way to be incentivized as a trader.
- Dual Asset Provision: For those seeking to enhance their participation, providing liquidity in pairs (e.g., ELYS and USDC) helps reduce slippage and typically results in lower fees.”
- Leveraged Liquidity Provision: For the more advanced user, Elys Network offers the option to leverage liquidity provision. This means borrowing additional funds to increase exposure, amplifying potential rewards but also increasing risk.
The Future of Liquidity Pools
The impact of liquidity pools on the DeFi ecosystem cannot be overstated—they are the engine that drives decentralized exchanges, enables seamless trading, and fosters market stability.
A DEX without liquidity is equivalent to a plant without water. It won’t survive. Liquidity pools provide a lifeline to DEXs.
As the industry continues to evolve, the need for innovative and flexible liquidity solutions will only grow.
Innovations in liquidity pool design, such as those pioneered by Elys Network, represent the next step in this evolution, offering more flexible, secure, and user-friendly options for traders and liquidity providers alike. By integrating advanced features like Oracle-Based Dynamic Weighted Pools and leveraging real-time data to mitigate risks, Elys Network positions itself as a key player in the DeFi space.
