Updated: Mar 31
Order Books vs Liquidity Pool
Blockchain is a revolutionized technology structure in the field of cryptocurrency. Considering the universal way of keeping our money secure in a bank or withdrawing it from an ATM (with or without a Pin code), blockchain is similar to this trading manner except for the fact that blockchain is decentralized and bank record is centralized, i.e. not giving full ownership.
To give further insight into the crypto world, this read provides detail about various terms of crypto methods and a comparison of exchange platforms.
Traditional Trading Method
Vanguard and Coinbase are two traditional trading services that act as a middle man for you to buy assets from a list of buyers and sellers usually referred to as an “Order Book.” The traditional method does not provide you ownership of your asset and instead holds it on your behalf as a middle man.
As opposed to the traditional method described above, Uniswap is the fourth largest decentralized cryptocurrency exchange structure that runs on the Ethereum blockchain.
A middle man is not required to operate this chain and users can control their exchange and funds without any intermediary involved. UNI tokens for this purpose were introduced in September 2020 to the crypto community, and currently have assets worth three billion dollars.
Uniswap is an open-source DeFi platform (Github) which operates on an automated liquidity protocol model that does not require an order book and instead uses a liquidity pool. This pool is created by LPs (Liquidity Providers) with zero listing process and no listing fees. If a liquidity pool is available for traders at a given time, then any ERC-20 token can be launched.
Uniswap uses two smart contracts “Factory’ and “Exchange.” Factory contracts support the addition of new tokens to the platform and Exchange contracts assist all the trades of tokens. A Liquidity Provider is anyone who deposits a pair of tokens to a smart contract in the exchange. Other users can buy and sell this trading pair, and in return the liquidity provider gets a percentage share of the trading fee earned from that pool.
The amount of share is redeemed in form of liquidity tokens that are provided to each LP as evidence of their share in a particular liquidity pool. One in-demand trading pair in Uniswap is USDC-ETH. LP must invest the equivalent (50-50) price of each asset in the liquidity pool, so one must need 50% USDC and the equivalent 50% ETH to invest in a pool for $1000.
As described above, LPs get their share for staked contribution, in the form of tokens. Liquidity providers receive a financial incentive at a rate of 0.30 percent of each trade. For example, if someone invests in the USDC-ETH pool, he holds equity on that pool and can claim directly based on his calculated share. If you want to exit from the pool, you trade your token to receive a percentage share of the accumulation fees.
AMM and calculation of token price
An automated market maker mechanism is used by Uniswap to calculate the token price by the mathematical term, based on the supply and demand of trading pairs.
A * B = k
Let’s review the above-mentioned USDC-ETH pool for a better understanding of token calculation. Let A be the USDC and B is ETH. Uniswap multiplies both quantities to measure liquidity in the USDC-ETH pool while k persists to be constant and represents total liquidity in the pool.
Now, if someone buys one ETH for 200 USDC, then the ETH portion automatically decreases in the pool, which automatically escalates the price of ETH in the pool because k must remain constant. So, this fluctuation in the ratio is what matters for determining the token price.
Access to Uniswap
This open-source platform has an effortless interface for usage https://app.uniswap.org/.
Reach Uniswap interface
Link Ethereum or any supported wallet
Select token you prefer to trade from
Choose a token you want to trade to
Press “Swap” and view transactions in pop up
Validate this transaction in the wallet
You can preview the status of the completed trade on https://etherscan.io/
Uniswap Vs CEX
DEX platforms have increased in their hype since DeFi and even surpasse some popular traditional services in the race of crypto space. Below are filtered essential points to interpret the comparison and differences.
The order book model is the backbone for the functionality of many CEX and DEX exchanges. For a particular token, all orders to be bought and sold are listed in the order book system as “Bid” and “Ask” respectively. The top of the book is made from highest bid and lowest ask and their difference is termed as the spread.
If a person buys/sells quickly on the best price at hand, then its order is referred to as a market order, where buyer and seller are paired based on top of the book orders. On the other hand, a limit order is when a person buys/sells a token at a particular price so that its order is listed on the order book.
This system works effectively for liquid markets where there is a large spread of buyers, sellers, and market makers.
It does not operate on non-liquid markets, since a person won't be able to trade if the highest bid is at low cost than the lowest listed ask.
Front running enables miners to view your transactions because you need to submit them on the blockchain before placing an order on DEX. Your information enables miners to earn effortless profit by placing a buy order in a block, if it predicts that your order will shoot up the price of a token.
Coinbase, Binance, NY Stock Exchange, IDEX, etc.
As described in the Uniswap process, a liquidity pool is a collection of funds deposited by LPs in a smart contract.
AMM trade lets you buy anything without a seller as long as there is adequate liquidity in the pool and your trade leaves an effect on the token ratio that is calculated by the algorithm. The order book is not needed in this model. LP is a peer-to-contract infrastructure, while order book works on peer-to-peer functionality.
Guaranteed liquidity regardless of the size of order or pool
Automated pricing eliminates the need to collect information across exchange for price calculation of assets.
This approach is impractical due to the huge level of slippage for large orders, as it requires massive pools in contrast.
Uniswap, Balancer, Kyber Network, etc.
“Yield additional crypto with your crypto” sounds amazing in the decentralized finance community, but it involves various complex yield farming strategies where traders revolve their money in multiple marketplaces to earn more rewards. The liquidity pool concept described above has yield farming as its use case.
Yield farming/liquidity mining involve farmers who try to pocket more rewards (high yield) by circulating their holdings via protocols. Yield farming technology mostly works on Ethereum, using ERC 20.
Its popularity is increasing daily in the DeFi ecosystem and it has the following working rundown:
LPs put funds (DAI, UDSC, USDT, etc.) in the pool to lock their crypto.
They add liquidity to the pool to acquire those tokens that are not present on the open market and possess low volume.
Your rewards are as good as the amount you invest, strategies you apply, and rules that a protocol uses.
Once you earn your share, you can reinvest those tokens into other pools actively on various platforms.
DeFi Pulse and TVL
The metric which is popularly used to measure the health of a yield farming money market, DeFi landing, or a liquidity pool, is known as TVL and stands for total value locked. It evaluates assets locked in the DeFi platform by use of DeFi Pulse.
The highest value of TVL shows the highest rate of yield farming happening on that system.
The top named list of farming systems includes Compound, MakerDAO, Uniswap, Balancer, YEarn.Finance, etc.
Significant players in field or liquidity mining are:
It is one of the finest among DeFi farming platforms, and rewards are given in the form of YFI tokens in this method. An automated yield farming scheme is applied in it through leveraging many landing pools and tokens can be burned for withdrawal at any time by paying a 0.5% surcharge.
The yield aggregation field has yet another competitor, harvest.finance, where one can conveniently perform yields. Farmers can deposit supported tokens and generate revenue in the form of assets. It saves investors gas cost and moves their equity around for multiple opportunities.
This is a popular competitor since it comes with a risk management structure. As compared to the above two, this strategy allows risk-adjusted yields, and the gas cost is saved up to 99% more than any other protocol. It smoothens the token obtaining process and alleviates risk and exchange-related charges.
The choice among diversified options highly depends upon gas fees, large savings, and easier access to crypto yield farming ecosystems.
Each technique has its own limitations. Uniswap V2 has come with noticeable features for flash swap and will offer compelling implications in the future. Ethereum 2.0 is expected to benefit many DEXs to make crypto exchanges mainstream.
What is blockchain? What is the decentralised web? www.dwebguide.com is accessible for beginners and useful for advanced users!