Automated market makers (AMMs) make it possible for decentralized exchanges (DEX) to provide liquidity for traders while automatically regulating the price of the tokens being traded. Liquidity providers, also known as LPs, deposit token pairs into liquidity pools which are then used by the automated market maker. In return, these liquidity providers get a share of the trading fees generated on the DEX.
While the current liquidity pooling model has proven popular with DEXs like Uniswap, there is a new method known as Directional Liquidity Pooling, which we will look at in greater detail.
What is directional liquidity pooling?
Directional liquidity pooling is a new method of providing liquidity to DEXs, developed by Maverick AMM. The main difference with this method is that it allows liquidity providers to choose how their liquidity is used by a DEX. When it comes to most DEXs in the decentralized finance (DeFi) space, liquidity providers expect the price of their deposited assets to remain constant while they collect trading fees. This is especially true when pairing a token with low volatility (i.e., blue chip coins like ETH) alongside a stablecoin like USDC. If the price of the asset pair doesn't change, then the liquidity provider can collect their portion of trading fees without adjusting their deposited token positions.
However, if the price of the deposited assets were to shift in any direction (i.e., increase or decrease), the liquidity provider could lose money due to impermanent loss. If the fees earned by a liquidity provider are not substantial enough, they may not be able to recoup their losses when this happens. Price changes cause impermanent loss because the automated market maker needs to re-balance the deposited assets by selling the appreciated asset for the depreciated or stable asset.
Since impermanent loss can be caused by any price movement, whether negative or positive, it is difficult for liquidity providers to protect themselves against this.
How directional liquidity pooling works
Directional liquidity pooling allows liquidity providers to choose how their liquidity moves based on the asset's price action. Liquidity providers can use the following methods to manage their liquidity:
Liquidity can stay constant, regardless of price movements (same as the current liquidity model)Liquidity can move to the right if the asset price increases while staying static if the price decreases.Liquidity can move to the left if the asset price decreases while staying static if the price increases.Liquidity can move in both directions based on the movement of the asset's price.
Essentially, directional liquidity pooling allows liquidity providers to manage their liquidity based on their expectations of the asset's price performance. If a liquidity provider expects an asset to appreciate, they can choose to have their liquidity move the right and earn additional fees if correct and vice versa.
In Closing
Directional liquidity pooling is an emerging method for liquidity providers to add liquidity to decentralized exchanges while optimizing their returns and guarding against impermanent loss. By assigning their liquidity to move in the direction of the asset's price, they can earn additional fees and avoid having to adjust their deposited liquidity if an asset price moves up or down.