On Decentralized Liquidity Mechanism: Taking Uniswap, Bancor, etc. as Examples

Author: Matthew Prewitt & Steven McKie

Translation & Proofreading: Chen Liang & A Jian

Source: Ethereum enthusiasts

Editor's note: Original title was "Decentralized Liquidity Mechanism"

Among the latest developments in the field of cryptocurrency, one of the most interesting phenomena is the emergence of a decentralized liquidity supply pool. For the financial market, ensuring the smooth entry and exit of funds is vital to its existence and development. , Good liquidity has also been found using financial market prices. It is very important for the development of the digital currency trading market to ensure that both institutional investors and ordinary traders can establish and drop trading positions at any time during the transaction. It is also a key step for the digital currency trading market to mature.

Decentralized payment methods are far from solving all problems.We also need the assistance of decentralized liquidity pools in order to build and expand additional financial network layers on top of blockchain-related protocols / applications. Liquidity is undoubtedly the most critical. It can achieve and help you realize the function of the agreement, but at the same time if you cannot reserve enough liquidity to support the growth of your project and support the products you develop for end users, then this agreement will be because Lack of liquidity and failure.

With the rapid development of decentralized lending-based financial business, the current blueprint of decentralized financial business has begun to look like the traditional financial market we are familiar with. In order to better understand the stage we are in now, we first Let's take a closer look at the solutions currently available in this industry.

Liquidity pool mechanism

(Editor's Note: The so-called "liquidity pool mechanism" means that users' funds are pooled to form a pool. Whether it is injecting or withdrawing funds, they interact with this pool, not with other users. This model A major feature (and benefit) is that you don't need to find a counterparty, you can trade at any time.)

First of all, the liquidity pool helps to solve the key problem for newly issued token projects: Before the project can really realize its value, it needs to work hard to start a liquidity providing network. When there are not many potential users of the project, the liquidity pool can provide liquidity support to token holders, alleviate the problem of insufficient token liquidity, and provide a unique, non-speculative reason for users to hold tokens. Of course, in this process, the liquidity pool will also charge a certain fee. In addition, the existence of liquidity pools has also removed some doubts from large investors who are unwilling to sell their tokens in illiquid markets. So, in a sense, the liquidity pool is a bit like providing insurance for token holders (we will explain in detail next).

Second, the liquidity pool should be seen as an impressive achievement in the construction of decentralized tools. For a long time, liquidity has been the focus of attention, not only in the field of cryptocurrency, but also in traditional financial markets. Liquidity is a prerequisite for the development of financial markets and financial institutions. However, the decentralized liquidity supply mechanism relies on a technology that does not exist in traditional financial markets-automated smart contracts-to provide liquidity. This is a completely new way to provide investors with a broader, More competitive participation in market making offers the possibility. Therefore, the liquidity pool is a sign of the maturity of the decentralized cryptocurrency market.

According to traditional financial market measurement indicators, these decentralized liquidity pools are still small but growing rapidly. The following is data on the total value of the US dollar locked in the Uniswap agreement (Translator's Note: that is, the liquidity in the Uniswap agreement Total), the data comes from https://defipulse.com/uniswap:

It is also worth researching here several leading liquidity pool providers, their operating mechanisms are different and not so simple, however, they are very worthwhile for investors, and if their size continues to grow, May change the views of large investors interested in the cryptocurrency market but concerned about liquidity risks.


Uniswap has grown into a leader in the field of decentralized liquidity pools. The liquid assets in its smart contracts are composed of 50% of Ethereum and 50% of other assets. Traders can purchase any kind of assets directly from the contract. At the same time, assets The price will change according to the algorithm. When the price determined by the algorithm deviates from the market price, the arbitrageur can wipe out the spread through arbitrage. Anyone can supplement the liquidity in the pool by contributing equal value of Ethereum and another asset Liquidity accounts for the entire pool) of the share of the transaction costs (0.3% per transaction rate) accumulated in the smart contract.

This article provides a good basic analytical framework for understanding the expectations behind providing liquidity to Uniswap contracts, and deeper research can be found here.


The Bancor protocol is the first truly decentralized liquidity solution in history. However, this solution is gradually losing its advantages because it has several technical flaws, and the operation of Bancor depends on its own tokens. (Making its solution less elegant than Uniswap's architecture). The biggest problem faced by liquidity pool providers like Uniswap is the relative price change risk between digital currency asset trading pairs. Therefore, it is ideal to provide liquidity with price-stable assets rather than volatile assets such as Ethereum, and Bancor's native token BNT is more unstable than Ethereum, making it more volatile.

In addition, the transaction structure on Bancor may lead to higher gas costs, and they currently have no plans to use Layer-2 expansion technology to alleviate this problem.

Bancor is working to solve these problems within the original framework, instead of introducing a new stablecoin to replace BNT as the underlying asset of its liquidity pool, and has not taken some other upgrade measures. Whether these solutions can improve the operating efficiency of the liquidity pool remains to be seen. However, automatic algorithmic pricing like Uniswap, coupled with assets that are tightly coupled with the operating layer (such as ETH) or stable coins built on ETH, seems to be feasible at the moment, of course, there may be better improvements in the future.

There are also projects like Kyber Network and 0x focusing on providing liquidity through cross-chain methods, and they are also promoting their ERC20 tokens, but this is not the focus of our research in this article.


Balancer is currently staying in the conceptual phase of the white paper, but it details a protocol that allows people to use larger, more diverse assets to create new liquidity pools that will be motivated by more accurate calibration algorithms The mechanism is promoted, and users can also trade independently. If this plan is successful, it will encourage wider user participation to provide liquidity.

The Convexity Protocol

According to the latest version of the white paper, Convexity Protol may become an important catalyst for the development of a decentralized liquidity supply mechanism. In this agreement, people can easily write an option contract with collateral in the form of ERC20 tokens. (OTokens) sold these contracts, which created more sophisticated hedging tools without intermediaries. Although the use of the Convexity Protocol can be said to be unlimited, the most likely business at present is liquidity insurance. Providers who are about to provide liquidity to new markets can use relatively stable assets as their underlying assets, so they can worry less because stable assets can hedge their risk of depleting liquidity in the target market.

Of course, there is no free lunch in the world, and in a sense, the Convexity Protocol can also be considered to "diffuse" the risk from a higher-risk market to a more stable market. Nevertheless, if the user fundamentals involved in providing liquidity continue to improve, such tools can make the decentralized liquidity mechanism more mature and accelerate the attraction of more meaningful, more categories of assets as the underlying assets of decentralized liquidity.

Unipig and StarkDEX

We need to pay attention to the link between liquidity and network capacity / throughput. The inability of the Ethereum main chain to process a large number of transactions quickly is an important obstacle that prevents liquidity providers from successfully providing liquidity. Therefore, the key to quickly eliminating the liquidity dilemma is first to increase the ability to provide liquidity. (For a deeper understanding of the nuances of this dynamic relationship, see the CFTC report on the 2010 "flash crash")

Therefore, in the process of improving decentralized liquidity, one of the most important solutions is to establish a two-tier network and off-chain solution to improve the rapid settlement capacity of a large number of transactions. Among many interesting projects, Unipig and StarkDEX As a representative, they all promise to significantly increase network capacity and execution time, but take a different approach.

The Unipig project has already produced a sample demo. People can publish a large number of transactions in real time to the aggregator running the full-featured Uniswap contract, and then aggregate these transactions and publish them on the main chain. Participants' trust in these aggregators comes from the punishment mechanism of the agreement. If any dishonest aggregator cheats, the security deposit it stores will be forfeited. This is a simple extension solution. Whether the participant can get incentives is closely related to the effective supervision of the aggregator. We are cautious about the Unipig team's ability to properly implement audit and verification mechanisms, and there is still some uncertainty as to whether large institutional participants are willing to provide liquidity through this channel. Nevertheless, we believe that their method of extending Uniswap with optimistic rollup technology is still one of the most mature methods to date. Without the use of snarks / starks technology, the learning curve for developers will be smoother, and they can get started faster.

On the other hand, StarkDEX uses the most advanced cryptographic technology STARK certification to process transactions. In order to improve transaction processing speed, they adopt off-chain calculations and batch transaction data on the chain. The difficulty of this approach is purely technical, not a social challenge like Unipig (you need to involve more people to provide mobility over time). According to the performance of the test network, StarkDEX processes more than 100 times the number of transactions per second on the main chain, and at the same time reduces the gas consumption accordingly.

It is unclear how the change in transaction time caused by this method is combined with the needs of major liquidity providers, and whether their solutions can be accepted by major liquidity providers in a short period of time. But optimistically, this is also a very critical step towards exponentially increasing throughput and access to decentralized liquidity support opportunities, and in the future it may also create and play an important role in scalable dark pool transactions under conditions of trust Roles.

Liquidity pillar

As we all know, the blockchain and cryptocurrency currency industries lack sufficient liquidity support. Except for the most popular assets, all asset markets cannot afford large transactions. The market volatility caused by large transactions will then cause a series of problems. First, price manipulation in the cryptocurrency market has reduced people's trust in this market. Second, people are nervous about holding cryptocurrency assets, which means that applications that rely on low volatility are difficult to launch. Third, due to the current performance bottleneck of the public chain, the functions of the decentralized exchanges and other decentralized economic models that rely on the public chain must not be well played. For example, the price information and matching efficiency of the decentralized exchanges are seriously behind Faster and more efficient centralized exchanges. Many previous research groups (and there will be future ones) try to solve the problem of liquidity through some centralized or centralized mechanisms, but this strengthens the connection between liquidity and decentralized ideas. Any financial system, in a sense On the other hand, its degree of decentralization is directly proportional to the diversity of its liquidity sources. After all, if it is only abolished the central bank, but let a few large asset holders perform the functions of the central bank, what is the difference from before?

If liquidity is provided by parties that are irrelevant, and a diversified supply of liquidity is guaranteed, then such a financial system is healthy: when a crisis occurs, the entire system will not collapse due to the problems of one institution. That's what the health system should have. Therefore, the health status of the decentralized financial system is basically the same as the health status of decentralized liquidity, that is, the more extensive and diverse the source of liquidity, the healthier the financial system. We are glad to see so many great teams working hard to tackle this critical issue and working hard to start a new stage of maturity and innovation in this area.