Decentralized finance (DeFi) has garnered significant attention in the last two years as excitement over its attractive yields and falling entry barriers have enticed investors from inside and outside the cryptocurrency universe.
However, without centralized intermediaries to facilitate different processes, like trading, DeFi has developed novel solutions to ensure markets function properly without rent-taking middlemen.
To this end, DeFi has been a very democratizing force, inviting the community to participate and be rewarded for effectively replacing traditional financial intermediaries in decentralized markets.
Just like liquidity is paramount for seamless price discovery in traditional financial markets, liquidity also plays a crucial role in decentralized markets.
How is liquidity replicated in a decentralized format? The answer lies in liquidity pooling. Liquidity pooling can be thought of as fulfilling a similar role as market-makers in traditional financial markets but in a fashion designed to empower anyone to facilitate trading and swapping processes.
Participants “pool” their tokens in a smart contract, which then provides liquidity to decentralized exchanges for trading and swapping activities.
Just like a market-maker receives compensation from the spread between the bid and ask prices, liquidity pools share the fees for executing transactions proportionally amongst the liquidity pool’s contributors.
This effectively means that liquidity is sourced from a community instead of a single counterparty like a market-maker, custodian, or exchange, reducing counterparty risk in-kind.
Still, despite the benefits of this newer model, liquidity pooling does carry some risks, namely from the smart contract. Smart contracts have been the epicenter of many bugs, hacks, failures, and exploits. Another serious risk is impermanent loss. This basically reflects the potential for a pool participant to lose funds based on fluctuations in the composition of the pooled assets between the time they were deposited and withdrawn.
Impermanent loss arises when the pool is rebalanced to maintain its aggregate value in a stable manner. That means that the original assets deposited might be withdrawn in a different ratio, creating the conditions for impermanent loss.
However, the prevailing idea of pooling is that incentives distributed amongst the pool will be enough to cover the risk of impermanent loss.
Reserve Coin OlympusDAO Moves Liquidity to Balancer Pool
Given the valuable role of liquidity in decentralized finance and the pace at which funds can move through the ecosystem, funds are constantly shifted to take advantage of the best conditions and yields available.
To this end, OlympusDAO is migrating $50 million of liquidity from SushiSwap to Balancer, an automated market maker (AMM) that aggregates liquidity.
The move, designed to broaden access to its reserve coin, will see OlympusDAO move treasury liquidity to a new pool on Balancer titled $OHM in the form of $25 million worth of $OHM, and $12.5 million of DAI and ETH apiece. This comes on the heels of a steep drawdown in liquidity on SushiSwap, which has seen total value locked in its protocol fall nearly 25% since November.
This latest move reflects the opportunity to offer users better returns on their pooled assets. As more protocols move into the DeFi space, famously high yields rapidly shrink, creating more significant incentives for liquidity providers to find the most attractive yield-bearing pools. With relatively low switching costs, the OlympusDAO decision also reflects this motivation.
Moreover, unlike other pools, this new $OHM pool constantly reinvests fees within the pool, incorporating unique measures to reward participants for pooling their assets.
Greater incentives are designed to attract more interest from potential pool participants and encourage greater use of the pooled tokens in the fundraising and trading processes, thereby completing the circle and building a sustainable pool.
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