Modern decentralized exchanges (DEXs) mainly rely on liquidity providers (LP) to provide the tokens that are being traded. These liquidity providers are rewarded by receiving a portion of the trading fees generated on the DEX. Unfortunately, while liquidity providers earn an income via fees, they’re exposed to impermanent loss if the price of their deposited assets changes.
Directional liquidity pooling is a new method that is different from the traditional system used by DEXs and aims to reduce the risk of impermanent loss for liquidity providers.
What is directional liquidity pooling?
Directional liquidity pooling is a system developed by Maverick automated market maker (AMM). The system lets liquidity providers control how their capital is used based on predicted price changes.
In the traditional liquidity pool model, liquidity providers are betting that the price of their asset pairs will move sideways. As long as the price of the asset pair doesn’t increase or decrease, the liquidity provider can collect fees without changing the ratio of their deposited tokens. However, if the price of any of the paired assets were to move up or down, the liquidity provider would lose money due to what is called impermanent loss. In some cases, these losses can be greater than the fees earned from the liquidity pool.
This is a major drawback of the traditional liquidity pool model since the liquidity provider cannot change their strategy to profit based on bullish or bearish price movements. So, for example, if a user expects Ether’s (ETH) price to increase, there is no method to earn profits via the liquidity pool system.
Directional liquidity pooling changes this system by allowing liquidity providers to choose a price direction and earn additional returns if they choose correctly. So, for example, if a user is bullish on ETH and the price increases, they’ll earn additional fees. Bob Baxley, chief technology officer of Maverick Protocol, told Cointelegraph:
“With directional LPing, LPs are no longer locked into the sideways market bet. Now they can make a bet with their LP position that the market will move in a certain direction. By bringing a new degree of freedom to liquidity providing, directional LPing AMMs like Maverick AMM open the liquidity pool market to a new class of LPs.”
How does this benefit users in DeFi?
The AMM industry and related technologies have grown quickly in the past few years. A very early innovation was UniSwap’s constant…
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