Liquidity pools make cryptocurrency trading viable and reliable when using DEXs. According to Wikipedia, LP is explained in that way:
“Uniswap uses liquidity pools rather than serving as market maker, also in contrast to centralized exchanges, with an aim to create more efficient markets. Users provide liquidity to the exchange by adding a pair of tokens to a smart contract which can be bought and sold by other users. In return, liquidity providers are given a percentage of the trading fees earned for that trading pair. For each trade a certain amount of tokens are removed from the pool for an amount of the other token, thereby changing the price. No fees are required to list tokens which allows a large amount of Ethereum tokens to be accessible and no registration is required for users. Uniswap’s code can also be forked to create new exchanges, similar to how forks occur with open-source cryptocurrencies.”
Uniswap explain how it works in a better sense, here is a short introduction:
Each Uniswap liquidity pool is a trading venue for a pair of ERC20 tokens. When a pool contract is created, its balances of each token are 0; in order for the pool to begin facilitating trades, someone must seed it with an initial deposit of each token. This first liquidity provider is the one who sets the initial price of the pool. They are incentivized to deposit an equal value of both tokens into the pool. To see why, consider the case where the first liquidity provider deposits tokens at a ratio different from the current market rate. This immediately creates a profitable arbitrage opportunity, which is likely to be taken by an external party.
When other liquidity providers add to an existing pool, they must deposit pair tokens proportional to the current price. If they don’t, the liquidity they added is at risk of being arbitraged as well. If they believe the current price is not correct, they may arbitrage it to the level they desire, and add liquidity at that price.
Using Uniswap as example, the process to provide liquidity to an already created pool is:
Therefore, a liquidity provider must provide liquidity to a pair of tokens, as an incentive he will receive part of the fees charged from traders. It is ok and fine if you have both pairs of tokens in equal proportion, but what if you don’t have the equivalent amount of another token?
It’s a problem that hasn’t been solved yet, some protocols try to solve part of it, such as Balancer, allowing liquidity provider to create pools with different amount of tokens, but even in those cases, it still is necessary to have more than one cryptocurrency, beyond the risk of low volume in some cases, what would make fees reward less attractive.
One solution is to create a kind of liquidity pool agnostic provider, where could be used any token to provide liquidity in an already created pool. Thus let say there is a pool Token A / Token B, the protocol would automatically create a match among people who have Token A and who have Token B, to provide liquidity there.
To illustrate, let call it ‘Themis Protocol’ (Themis is the Roman goddess of justice, she portrayed blindfolded to represent impartiality) and exemplify with LINK/ETH pool, it could be resumed in the following diagram:
On the left side are LPs (described as “user1”, “user2”, etc) who have Chainlink, the right side are people who have Ether, the Gauntlet Protocol joints all equivalent amount of tokens in each cryptocurrency and provides liquidity to LINK/ETH pool on Uniswap.
Some cryptocurrencies have more volume on pools, given its higher usage, Ether is an example, in those cases, such token could be allocated in a larger room to be paired with any other token, it would be a liquidity pool agnostic provider, as in the diagram:
As an incentive, liquidity providers through Themis Protocol continue to receive rewards on fees charged from traders, the rewards also continue being distributed in proportional amounts according to their participation in the pool.
When someone decides to remove liquidity, his part is transferred back along with rewards, and the other pair returns to another pool matching with someone else waiting to join a pool.
The impermanent losses must be considered and ensured that all liquidity providers are in a positive balance, so one way to that transfer proportionally for each one his respective amount and rewards based in eth, per example. Another way is to distribute a token from part of Themis Protocol, separated to rewards users of the protocol.
Themis Protocol token also could be used as an incentive to liquidity providers that are providing liquidity with tokens in high usages, such as Ether, which could gain more rewards.
It was a brief proposal resume, some adaption can be made, there are some details to be adjusted, but nothing that would invisibilize the protocol. Being it solved, anyone who holds any token for the long term can benefit from it without the necessity to have another token.
