There will be a closer look at DEXs’ liquidity pools and automated market makers, as well as yield farming. DeFi is the subject of an ongoing series, the third installment of which is presented here.
Traditional finance and how it operates are well-known to financial advisors. Custodians like Fidelity, Schwab, and IBRK, which have links with stock exchanges like the New York Stock Exchange and Nasdaq, are clients of registered investment advisory firms.
Trading of individual securities takes place on stock exchanges, while portfolios of securities are held in custodianship by financial institutions. The custodians’ platforms are accessible to clients of financial institutions, and advisers can manage their clients’ assets through the custodians. It’s been this way for a long time in the traditional banking system.
Decentralized finance (DeFi), on the other hand, is vastly different from traditional banking. It is critical for financial advisors to become familiar with this new system so that they can explain it to their customers and assist them in recommending crypto assets to them.
At the heart of DeFi are what are known as “DEXs,” or decentralized exchanges. To continue this series on understanding DeFi, I wrote about the significance of DEXs in last week’s email. Digital asset exchanges (DEXs) allow consumers throughout the world to trade digital assets.
Order books have been used for decades and, to be honest, still work today in centralized exchanges like the NYSE. DEXs don’t use the order book system because it requires a team of centralized employees and technology to run.. DEXs, on the other hand, use smart contracts to make trading easier. A liquidity pool is a name given to the smart contract that oversees trading on a DEX.
What’s a liquidity pool, exactly?
The DEX uses a “liquidity pool” to trade crypto assets, which is just a pool of locked assets regulated by a smart contract (or piece of software code). One person or institution does not pledge all of the pool’s combined assets; they all come from a variety of individuals and organizations. As is typical of the decentralized and grassroots nature of the cryptocurrency movement, liquidity pools are built with the help of the wider crypto community and its members. To put it another way, a liquidity pool is a big pot of coupled assets that make it easy to move money around.
What are automated market makers?
Trading in digital assets on a DEX is made possible by the use of liquidity pools, which are managed by automated market makers (AMMs), software code that governs and automates the process of swapping assets and supplying liquidity. As opposed to typical order book systems, AMMs allow users to trade against a pool of matched assets rather than a single counterparty (think of buyers and sellers).
An AMM can only be understood if one is familiar with the mathematical formula at its heart:
X * Y = k
After Vitalik Buterin presented the AMM formula in a blog post on Ethereum, AMM protocols were created. Token A is represented by X, Token B by Y, and a constant balance between the two tokens is represented by k in the formula.
The constant, k, remains the same if the price of X grows and the price of Y drops in a liquidity pool. New assets are only added to the liquidity pool if they are pledged to it. This formula manages the liquidity pool and maintains equilibrium between token prices. For example, if you buy token A, the price of token A will rise, whereas selling token A will lower the price of token A. Token B, which is in the liquidity pool, will experience the exact reverse. Read also; Artificial Intelligence Can Fuel Africa’s Economic Growth
The arbitrage feature is another component of AMMs. These smart contracts are able to compare the prices of paired assets in their own pools with those in the DeFi ecosystem.. In a situation when the price fluctuates excessively, the AMM will encourage traders to exploit mispricing in both the native liquidity and the outside pools, allowing the native AMM to return to equilibrium.
Understanding yield farming
AMMs not only encourage traders to arbitrage cross-pool prices, but the actual liquidity pools encourage members to pledge assets to the pools themselves. Token holders have an alternative to merely relying on price appreciation in the form of yield farming, which is a popular technique to create money in the crypto ecosystem.
Tokenized incentives begin to accrue as soon as a person contributes paired assets to the liquidity pool. To facilitate asset swaps through a pool, the user is charged a nominal fee by the pool. Individuals who have pledged assets to the pool receive a portion of this charge. Liquidity provider tokens (LP tokens) are typically used to pay this cost.
A decentralized exchange like PancakeSwap allows users to pledge assets to a liquidity pool, for example. In return for providing liquidity, PancakeSwap will pay the user in CAKE, the native LP token that PancakeSwap invented, and the pledger will get a return on his pledged asset according to the AMM. This allows the user to exchange his LP token for any other cryptocurrency he wants.
What to be careful about
When it comes to producing farming, caution is essential. In the case of new asset pairs with little liquidity, a high return on investment is often offered to entice investors to participate to the pool. Users are more likely to be a victim of fraud or theft because these pairs and pools are new. A “rug pull” exit scam is a popular method for criminals to evade detection in new pools. In this scam, tokens are collected from the community by the creators of a project, but the initiative is abandoned before the tokens are repaid. Read more; Coinbase suggests crypto tech to help with worldwide sanctions
During times of significant volatility, which is usually in the bitcoin market, there is also the chance of temporary loss, which is another type of risk. One token in a pool may move more than the other, and liquidity providers may elect to remove assets from that pool. Individuals who have committed assets may have less than their original commitment if this happens. As long as the liquidity provider keeps assets in the pool, it is possible that the liquidity value recovers to break-even given sufficient time and a decrease in volatility.
Navigating a new system
In light of this, how can a financial advisor deal with the additional risks that come with asset flipping, decentralization, and yield farming? Remember that the existing banking system is here to stay for the foreseeable future. DeFi’s blockchain technology, on the other hand, has a lot to offer financial service providers as well as end customers.
Advisors should be familiar with the workings of DeFi technology and ready for it to expand in the coming years. Increased customer satisfaction is assured as a result of the lower operating expenses and increased effectiveness.