SFM Labs - Liquidity and liquidity pools in DeFi
This Twitter Space took place on 14.03.22 - 2 PM EST 7 PM GMT 8 PM CEST.
A quick disclaimer upfront: All information given in this presentation is researched and intended to be educational and illustrative to the specific topic as always. Every owner has to do their due diligence, as the owner's decisions and responsibility about any investment lie with themselves.
What is liquidity?
The term liquidity is generally used in financial markets to describe the ease with which an asset can be converted into cash or other currencies without difficulty. Money is referred to as the most liquid means of payment in the world because it is widely available in its simplest form and can be easily traded, converted, and exchanged. The matching counterpart in cryptocurrencies is the stable coin.
Exotic goods such as scarce cars, collector's items, etc., represent the less liquid means here, as these have to attract specific buyers who agree to a trade due to the restricted market. This reduces trading opportunities and delays trading, so these goods are not considered particularly liquid.
In relation to cryptocurrencies, liquidity means the ability of a token or coin to be easily converted into cash or other tokens or coins. The ease of trading refers to the means and channels available, such as a token or coin on exchanges, open platforms, or similar. For example, you can trade dollars in bitcoin, and it can be done easily and quickly in the trading pair BTC/USDT. A new coin or token, on the other hand, will only be tradable via the small area on which it was launched, for example, on PancakeSwap only.
The availability and liquidity at the respective trading venues are essential because the lower the liquidity, the more volatile the trading and the higher the spikes. Conversely, very high liquidity and availability across different trading venues is a more comfortable way of trading, as there are lower spikes in the graph when changes occur.
What is a liquidity pool, and how does it work?
A liquidity pool is an entity in which assets are included in a collection that the Smart Contract locks in. It offers the possibility to trade tokens and coins within this trading range under the given trading conditions, available cryptocurrencies, and trading channels. In extended use, liquidity pools can also be used for lending and borrowing. The number of cryptocurrencies lent out in bulk is repaid at an interest rate that leads to an increase in liquidity.
Well-known exchanges on Ethereum, such as SushiSwap, Curve, etc., also use liquidity pools. These control the liquidity for the trading and exchanging of the ERC-20 tokens published and traded there. For the BNB-20 token, this is handled by PancakeSwap, SWaP by SafeMoon, BakerySwap, and others.
Some essential pieces to liquidity pools are liquidity providers, liquidity tokens, and automated market makers.
Liquidity providers are those who make their cryptocurrencies available to the liquidity pool in a so-called trading pair. For this purpose, the traded main currency and another trading pair are usually used; in the case of SafeMoon, for example, this is the trading pair SFM/BNB. In return, the holder receives a liquidity token (also called LP token), a certificate of sorts, confirming that the amount entered by the holder is available in the liquidity pool. If the holder wants to remove his liquidity from the pool again, he must exchange the token to receive the trade back the trading pair he provided
The accumulation of liquidity in the entire pool in relation (in percentage terms) to the value provided is rewarded with partial rewards. Each deposit placed in the pool receives a proportionate share of the increase in value due to the expansion of the liquidity pool.
It is essential not to lose sight of the risk of impermanent loss. This is the risk in which the price of token changes in comparison to the monetary value deposited in such a way that the difference leads to a loss of monetary value. Since the monetary value of currencies is constantly fluctuating in the crypto space, the risk of a larger monetary loss is greater when trying to profit on a particular trading pair in the short term. Therefore trading here is recommended for those who want to generate a passive source of income in the longer term.
The automated market makers (or AAM protocol) is an addition that makes trading a little easier and cheaper. AMM is a protocol that ensures direct trading without an intermediary. Thus, in the case of liquidity, a peer-to-contract instead of a peer-to-peer is given since one has to trade directly with the smart contract and no bank or trading post.
What types of liquidity pools do exist in Defi?
There are many different types of liquidity pools used in the Defi space. The three main uses are yield farming, token distribution, and governance.
1. Yield farming
Yield farming provides the user with a way to automatically generate money by providing liquidity and growing his stake over time. The best and most well-known example of this is Yearn Finance, where you can use automated yield generation. By providing the funds, the operator generates money through the further use, trading, and lending of the funds distributed in parts.
2. Token distribution
There are two forms of token distribution: reallocation and compounding.
In reallocation, when mining tokens on a platform, a portion is distributed to those who have provided money as a basis for its trading.
In compounding, an increase in the monetary value is applied through the permanent reinvestment of the distributions of a token to the matching liquidities. These are integrated into the borrowed portion and reapplied, thereby increasing the mass of interest.
Liquidity pools and provided liquidity can also be used for governance. Here, liquidity can be used to make governance or investment decisions in a community (such as a DAO) based on the funds provided.
Can you provide liquidity to SafeMoon?
Yes, you can provide liquidity at SafeMoon. For this, you need a pair, for example, SafeMoon, and BNB, which must be available in equal parts (the counter value of both cryptocurrencies must be equal). Then you can provide this to the web swap. This passively generates profits over time with rewards of the liquidity pool automatically measured by the amount of money contributed.
Important information at this stage: Please do NOT provide liquidity at this time due to the integration of cross-chain SafeMoon is asking everyone to remove their provided liquidity from the pool for this transition. I emphasize: Please refrain from providing Liquidity now. After confirmation of the completion of the router upgrade on March 23, 2022, from the Core Team or the official SafeMoon - Account @SafeMoon, this feature can be used again. Any disregard of this warning will result in a loss of funds. If you have currently provided liquidity in SWaP by SafeMoon, we ask you to remove it and use it again later on the mentioned date after confirmation.
The future of liquidity pools
Liquidity pools are the cornerstone for financing and trading projects. It isn't easy to set up an expansion of a project in the defi system without them. There are currently even approaches to almost completely dispense liquidity pools and let the trade take place directly between users and the given quantity, which works to a certain extent. However, projects that have a larger scope and would like to use the liquidity for other purposes currently refrain from this method. Security is always in the foreground here. Securing liquidity against hacker attacks by distributing it across different secured or insured wallets is the right step here, but improving the systems will also take place more in the future. It is important always to let the liquidity grow through the benefit of the project or the project itself so that a shortage and thus unnecessary volatility and risk creation can be avoided.
At SafeMoon, this will be done through Swap and evolve in the future, which should help us stabilize our project and expand the opportunities to strengthen our ecosystem. And knowing our team, we know that this will lead to an expansion of our liquidities and security given to the holder itself because it allows SafeMoon to grow without hesitation.