A directional liquidity pool is a good opportunity for liquidity providers to increase liquidity on exchanges by pooling their funds.
Modern DeFi Exchanges (DEXs) mainly use Liquidity Providers (LPs), which lock their tokens and coins to make them available to traders.
This ensures that exchange transactions are done almost instantly and traders can exchange any amount of assets they want.
Liquidity providers receive rewards for the supply of liquidity, which is formed from a certain part of the trading fees collected by DEX.
However, the provision of liquidity also carries certain risks. By locking their assets to earn income from commissions, traders lose the value of the locked assets in the event of a drop in their price.
What is directional liquidity pooling
Directional liquidity pooling is a new way used by DEXs to reduce the risk of loss for liquidity providers.
Directional liquidity pooling is a system developed by Maverick automated market maker (AMM). The system allows liquidity providers to control how their capital is used, based on predicted price changes.
In the traditional liquidity pool model, liquidity providers receive the maximum profit if the price of an asset moves in a sideways direction without changing significantly.
However, any significant price fluctuations result in increased risks due to possible forced liquidations or, in the event of a drop, the risk of losing the value of the asset.
In some cases, such losses may be greater than the commissions received from the liquidity pool. This makes locking funds in liquidity pools unprofitable and discourages potential liquidity providers.
Directional liquidity pooling allows liquidity providers to reduce their risks and increase possible profits by choosing the right direction of price movement to get additional profits in case of the right choice.
For example, if the user is optimistic about ETH and the price rises, he will receive additional commissions.
Benefits of directional liquidity pooling
Directional liquidity pooling allows liquidity providers to set the range they want and choose how liquidity should change as the price changes.
In doing so, the AMM smart contract automatically changes liquidity, allowing liquidity providers to keep their money working regardless of price.
Liquidity providers can choose to have the automatic market maker move their liquidity based on changes in the price of their pooled assets.
Currently, liquidity providers have four different modes to choose from:
Static: As in traditional liquidity pools, liquidity does not move.
Right: Liquidity moves to the right when the price is rising and does not move when the price is falling, in the case of bullish expectations of price movement.
Left: Liquidity moves to the left when price is falling and does not move when price is rising in the case of bearish expectation of price movement.
Both: Liquidity moves in both price directions.
The liquidity provider can put one asset and make it move with the price. If the chosen direction matches the price movement of the asset, the liquidity provider will receive trading commission income while avoiding unexpected losses.
When the price changes, a loss is recorded because AMM sells a more valuable asset in exchange for a less valuable asset, leaving the liquidity provider with a net loss.
Directional liquidity pooling represents a significant expansion of the opportunities available to LPs. Under the current model, liquidity providers have maximum profits only when prices are stable.
If the market fluctuates, they are more likely to incur losses than earn commissions. This keeps many potential liquidity providers from operating in the DeFi market.
Directional liquidity providers can limit their losses with single-sided pooling. Single-sided pooling allows the liquidity provider to place only one asset.
If a loss occurs in the case of putting the wrong price direction, it can only occur with this one asset. Thus, participation in directed liquidity allows liquidity providers to control the balance of their profits and risks.