User-Owned Exchanges
If you hold a project’s token, you can now easily acquire a piece of its liquidity on a DEX and collect fees from its trade volume.
The ability to stake your tokens to an exchange and generate fees from its trading volume not only introduces new opportunities for users to earn passive income, it also fundamentally changes how DEXs operate.
We can now build user-owned exchanges that efficiently pool liquidity from the bottom up — that is, from everyday users, instead of liquidity creation being reserved for whales and professional market-makers.
At the heart of this development is a new financial primitive called the liquidity pool. Liquidity pools are automated market maker (AMM) smart contracts that exchange assets algorithmically using on-chain reserves.
Liquidity pools form an autonomous, decentralized incentive layer that allows for broader, more competitive involvement in market-making. DEXs based on liquidity pools are effectively user-owned exchanges where:
- The core operations of the exchange — listing tokens, order-matching, circulation of trading fees — are performed autonomously by a permissionless set of smart contracts.
- Users who participate as liquidity providers add liquidity with no central entity controlling the process, so liquidity can be decentralized across an infinite number of unaffiliated parties.
- Liquidity providers are incentivized to drive more liquidity, since higher liquidity attracts more trades, earning them higher trading fees.
These dynamics stand in stark contrast to the way modern-day crypto exchanges work. Up until now, market-making has been highly technical, requiring large amounts of capital and complex trading strategies. These barriers to entry create exchanges where liquidity provisioning is concentrated among a handful of institutional players and whales who partner with the exchange to capture trading fees.
Liquidity pools allow an exchange’s liquidity to flow from a decentralized network of unaffiliated liquidity sources, providing greater resilience and resistance to censorship.
Any developer or user can tap into this permissionless liquidity. For example, we’ve seen the emergence of numerous alternative interfaces built atop Bancor smart contracts which allow users in any geography to trade tokens on Bancor and add liquidity to Bancor pools.
One headwind pushing decentralized liquidity into the fore is the dismal state of liquidity on most crypto exchanges, especially for tokens outside the top 20. Low liquidity plagues not only decentralized but also centralized exchanges, leading to high slippage costs for traders and price manipulation.
Putting everyone’s tokens to work in on-chain liquidity pools may be one solution to add transparency and broaden the distribution of market-making rewards to a greater share of token communities.
Another sign that decentralized liquidity is approaching a tipping point is the growing number of DeFi users and crypto projects getting involved. Various token-based protocols have started utilizing liquidity pools as a mechanism for deploying incentives to their holders and distributing ownership of their protocols through so-called “yield farming” or “liquidity mining”.
Soon, every exchange could be owned by thousands of users, and DEXs may start to look a lot like DAOs.
To be fair, our collective understanding of liquidity pools is still rapidly evolving. We’re still learning what combinations of assets and what parameters can be used to maximize profitability for LPs and offer competitive pricing for traders — two objectives which are often at odds.
But the fuse has been lit and the mainstreaming of market-making via AMMs is now fully underway.
To learn more about liquidity pools:
- Join the Bancor Dev community on Telegram
- Follow Bancor on Twitter
- Dive into the Bancor Developer Docs
- Subscribe to the Bancor blog
