June 17, 2022

How market makers may benefit from DeFi

The world of decentralized exchanges blossomed in 2020, with monthly trading volume skyrocketing from $666 million in January 2020 to $68 billion in January 2021, a 100x increase. Needless to say, the sector is still in its early stages of development. DEXes are experimenting with new trading venues, traders are testing new features, and market makers are seeking new ways to increase their earnings.

Without crypto liquidity providers, no crypto exchange can survive. At the same time, without appropriate liquidity, no token can succeed. Only tokens with a low spread (the gap between the bid and ask price) and sufficient liquidity will attract cryptocurrency traders and investors. This necessitates collaborating with a crypto liquidity service.

A decentralized exchange allows agents to trade one asset for another without the need for a centralized third party to monitor trading activities. In the past, centralized exchanges dominated the cryptocurrency sector, with many of them experiencing devastating downfalls and losses that have only fueled the drive to make DEXs succeed.

Decentralized finance may be quite a young sector, unlike TradFi, but it attracts more and more users, investors, and, of course, liquidity providers. But what can the decentralized world offer to market makers that traditional finance can’t? There are several reasons for DeFi to be popular among market makers and here are some of them.

Automated Market Makers and Fees

Automated market makers (AMMs) are part of the decentralized finance ecosystem. They use liquidity pools rather than a traditional market of buyers and sellers to allow digital assets to be traded permissionless and automated.

Liquidity providers are encouraged to add more assets to the liquidity pool via AMMs. When users facilitate trades through a pool, liquidity providers receive fees every time a transaction is completed. This charge is automatically collected by the DEXes and primarily allocated to those who provide liquidity on the particular DeFi platform. Transaction fees are split evenly among all liquidity providers in the pool, thus the more crypto assets you stake, the more fees you'll receive. This is the most common way for market makers to benefit from the DeFi sector. Although this method of providing liquidity is somewhat passive, it is not without risks; specifically, an impermanent loss and a high level of exposure to a token in need of liquidity.

Arbitrage Pools

Another important service that market makers might provide is arbitrage across the many platforms where a token can be traded. Because of the normally high liquidity of assets in traditional markets, arbitrage, which involves buying and selling an asset that is priced differently on several exchanges, isn't as popular in ordinary markets as it was. Many cryptocurrencies on DEXs, on the other hand, have lower liquidity levels, which means arbitrage possibilities are accessible for longer until liquidity levels are correct. Because liquidity pools are completely decentralized and independent of one another, arbitrage provision is essential to keeping AMM protocols running properly.

Concentrated Liquidity Provision

Some DEXs allow liquidity providers to concentrate liquidity in a specific price range. Concentrating liquidity in this manner translates to high capital efficiency and yield opportunities since liquidity providers’ capital isn’t spread thinly across all prices. The provision to stack liquidity in a specific price range — where trading is likely to occur in the immediate to medium term — drastically magnifies the liquidity provider’s efficiency. In turn, this allows them to potentially earn more rewards from the same capital.

Single-Sided Stacking

Some protocols allow market makers to supply liquidity to a pool with a single token and keep full exposure to the token. Many protocols, on the other hand, require liquidity providers to take on multiple asset exposure. With single-sided liquidity, a market maker may stay long on a single token and be exposed to the same price movement as if the tokens were in their wallet, only they're in protocol supporting trading and receiving a portion from transaction fees and mining rewards.

Order Book Based DEXs

Order book based DEXs utilize the central limitorder book (CLOB), which is a trade execution model that matches buyer andseller orders based on a set of rules. The process of fair price creation atwhich the deal would be performed is the main distinction between trading on anAMM-based exchange and trading on a CLOB-based exchange. Market makers offerliquidity for central limit order books by putting a list of limit orders onboth sides of the trade. To encourage liquidity, market makers will get a net positivefee refund, which will be distributed through snapshots on a frequent basis.

Accessibility

Another important feature of AMMs is their accessibility. Anyone with an internet connection and any needed token can participate in a liquidity pool.

AMM is a DeFi technology that allows users to trade at any time. Its first defining feature is that it opposes the traditional buying and selling system. There are no regulations or gatekeepers, so anybody with sufficient expertise and digital assets may become a DeFi liquidity provider.

The values of crypto and blockchain technology, in general, are embodied in this new way of trading assets: no single entity controls the system, and anybody may create new solutions and participate.

Yield Farming

Token awards are offered by some AMMs to stimulate liquidity provision. Liquidity providers might generate additional yield by using these AMMs in a process known as "yield farming."

Users just need to upload a suitable amount of assets to a liquidity pool to engage in yield farming. The AMM will automatically gather reward tokens when the contribution is validated, which the liquidity provider may claim on a regular basis. The more liquidity market makers offer, the more reward tokens they earn.

Governance Tokens

In a decentralized protocol, governance tokens signify ownership. They grant token holders particular rights that allow them to affect the course of a platform. This might involve deciding which new products or services to create, how to allocate resources, which integrations or partnerships to pursue, and more.

Some DeFi networks compensate market makers with governance tokens as a specific benefit for creating liquidity. So, in addition to the fees they regularly receive, a market maker might gain a portion of ownership of the project if they choose the suitable platform.

Vast Variety

Nowadays, there are hundreds of DeFi projects. Each one has its own set of benefits and features for its users and market makers. Liquidity providers may select a project based on its scale, features, tokens, and users, among other factors. This industry is still expanding, and its users and servants will have even more opportunities in the future.

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