In 2023, the buzz around decentralized finance, or DeFi, is inescapable. Conversations around DeFi are not limited to just crypto aficionados but have permeated the general populace. Poised to catalyze a transformative shift akin to the internet's impact years ago, DeFi offers a novel approach to traditional finance systems. A standout feature? Governance tokens, empowering DeFi users with the autonomy to mold a project's direction, bypassing conventional boardroom decisions. Given its inherent advantages over centralized counterparts, it's no wonder the DeFi realm has witnessed exponential growth and the emergence of myriad innovative projects, one such being Yearn Finance and its associated YFI token.

Yearn's trajectory in the crypto space has captivated many. Reflecting on its journey, after its public launch in July 2020, the Yearn token's value catapulted from $3,000 to a staggering $67,000 by 2023, with a notable peak of over $90,000 in 2021. Boasting a market capitalization exceeding 2 billion, YFI has solidified its position as the 56th largest cryptocurrency—a commendable feat for a project still in its nascent stages.

Having laid out the foundational understanding of Yearn, it's time to delve deeper: What exactly are the mechanics of the Yearn Finance protocol, and what sets its YFI token apart?

With its native YFI token, Yearn Finance promises to provide an easy way to access high yields for crypto holdings. The project’s founder Andre Cronje, is a South African entrepreneur and tech developer well known in the DeFi community. Cronje came up with the idea for Yearn as a way to solve  yield inconsistencies  on DeFi platforms. 

Admittedly, Yearn Finance can be a little complicated to grasp for newbies in the DeFi space. So let’s break down how it works so you can better understand why Yearn is an important DeFi project. 

As soon as you enter the Yearn platform you are presented with five options on the homepage: 

Through these options, the Yearn protocol provides lending aggregation, yield generation, and insurance on the Ethereum blockchain. In other words, Yearn gives its users alternative finance options through its decentralized protocol. 

The most impressive feature of Yearn is its Vault. This option has been Yearn’s main selling point, and it’s no surprise as to why. With Vaults, users can hold a crypto asset and earn a yield from their deposit. As an example, let’s say you love Chainlink (LINK). Thanks to Yearn , you can deposit your LINK tokens into your Yearn Vault and earn more LINK from your deposit. Depending on the cryptocurrency deposited, the returns can be impressive, sometimes as high as 70-80% in some cases.

Vaults manage to achieve these staggering results via a complicated financial process, that we’ll try to break down as much as possible. First off, users deposit a digital asset into the Vault. Then, Yearn uses the deposit as collateral and borrows stablecoins in its place. The protocol uses these stablecoins to find and invest in yield farming opportunities. It then shifts and rebalances the investment when the market changes.

Profits made from investing yields are then converted back into the token you originally deposited. So, if you put some ETH in the Vault program and receive the yield in COMP, it will convert the gained COMP back to ETH.

One of the best Vault features  is that it’s designed so the community can work together to find, plan, and vote for the best investing strategy.

By structuring the Vault in a collective way, users can minimize one of the biggest problems for the DeFi community, gas fees. By using Vaults, your gas fees will be significantly lower than what they would be if you were to replicate the same yield-farming strategy on your own.

Earn allows users to deposit one of the following stablecoins: 

Yearn Finance transfers your stablecoin deposits among the main DeFi lending protocol platforms. Generally, it oscillates between three different protocols to earn users the highest possible yield: Compound, DyDx, and Aave.

But as Yearn Finance grew, it had to evolve. Earn cannot simply find the highest yield pool and dump all of the funds in one place. Doing so would drastically change the investment yield, as an influx of capital would increase market supply and affect interest rates. Instead, Earn is designed to adjust and find the optimal portfolio allocation.. Since users are continually withdrawing from the pool, Earn automatically rebalances funds to optimize the yield for the entire pool.

But you may ask, why can’t I go to a DeFi lending protocol likeAave and supply the liquidity myself? Of course this is something you could do, but doing so would require you to monitor the investment constantly. With Earn, this hassle is a thing of the past.

The Yearn Zap feature allows users to convert to any available Yearn Finance crypto pools, quickly, conveniently, and with a reduction in cost.  Currently, users have five stablecoins at their disposal BUSD, DAI, USDC, USDT, and TUSD. ZAP can convert that into the y.curve.fi or busd.curve.fi pools. Or users can “Zap” out of the pools into the previously mentioned stablecoins.

Cover is the newest implemented feature, and it’s very interesting. Its main focus is on the  insurance that protects users from losses resulting from Ethereum smart contract hacks or bugs. This is all completed through a decentralized insurance model built on the Ethereum blockchain. Additionally, Cover integrates with a project called Nexus Mutual, a protocol that excels at providing smart contract insurance. This is a great way to protect yourself from any unforeseeable smart contract failures that could result in you losing funds.

What about the YFI coin? And how did it reach $69,000?

In simple terms, YFI is the governance token for the Yearn.finance protocol, and DeFi enthusiasts have loved it from the start. The token immediately caught the attention of investors after the project’s founder Andre Cronje didn't pocket any tokens before the ICO, showing his commitment to the project. He gave it to people involved in creating key liquidity pools essential for the project’s birth.

Situations like this are very rare. But when it happens, the community loves it because it displays a founder’s dedication to creating a fair and equitable token to be shared throughout the community.

You also might be asking why the price of YFI is so high? This is because there is only a circulating supply of 30,000 YFI tokens. With such a low supply, the price has to rise substantially in order to meet demand.. Such a small supply is quite unusual for a DeFi project. Although according to the YFI whitepaper, more can be minted through the protocol’s governance process if needed. However, as of now, the community and the developers have expressed no intention of minting new YFI tokens.

The YFI governance process is easy for holders to participate in; all they have to do is stake their YFI coin to the protocol, and doing so, they earn the right to cast a vote on proposed initiatives. The only downside is that the token holder has to keep their coins staked for at least three days after voting on a proposal. Fortunately, they will earn a reward for doing so.

Yearn Finance charges  users 5% on some types of withdrawals. This is mainly to maintain its treasury, which needs $500,000 to function. Any excess capital in the treasury is distributed among YFI coin holders. This is a great way to incentivize users to hold the YFI token. The more users the network acquires, the more token holders will earn. But remember,  Yearn Finance will only give this dividend to users who participate in the vote.

But what happens to my tokens when I deposit?

When tokens are deposited on Year, the user gets another token back in return for what was given to the liquidity pool. Newbies may be confused at first about how this works, but this is a very important yield farming characteristic.

This process may at first seem like a savings account, but that’s not the case. When you deposit your money in a bank's savings account, all you get back is a receipt of the transaction.

On Yearn Finance, deposits yield tokens. And these tokens allow anyone who holds them to redeem them. This is one of  the main concepts behind DeFi.

For instance, on Yearn, users that deposit their funds will get yDAI back. Similarly, on Aave, they’ll receive aDAI and on Compound cDAI. The tokens, plus any earned interest, can be redeemed whenever the depositor sees fit.

This is game-changing because, in contrast to bank deposits, these tokens can be traded or even deposited in other places. This concept is better known in DeFi as composability.

In the beginning, Yearn Finance could only do this with stablecoins, but as the protocol grew, it developed Vaults for more complex crypto assets such as LINK and ETH.

What can depositors do with their yTokens?

As we previously mentioned, in DeFi, the tokens users receive after they’ve deposited their funds can be in turn traded and deposited elsewhere.

On Yearn Finance, stablecoins are the primary deposits because users can easily see how much they are earning. But keep in mind that when a user deposits a stablecoin like USDT and gets yielded back yUSDT, the second cannot be considered a stablecoin.

Yearn Finance found a way to make it easier for depositors to move their funds between different pools. The platform works with Automated Market Maker (AMM) Curve and creates USDC, yDAI, yTUSD, and yUSDT pools.

Consequently, Yearn Finance users can switch between different tokens on the platform by using Curve, like moving from yDAI to yUSDT as an example. And not only that, on Yearn Finance, a user can increase their yield by adding it to another pool and earning from there. Users will receive gains in yCRV, Curve’s native token.

Aditionationally they can also deposit their yCRV and receive yUSD, also known as yyCRV, in return.

A closer look at the Yearn Finance community

Like all DeFi projects, the Yearn community has a central role in the development and governance of Yearn Finance. Decisions are discussed and developed on Yearn’s governance forum. Community members discuss, create, and vote on new strategies for Vaults. This system incentivizes community members to find the least risky and most profitable strategy as a group as their own profit potential is directly affected by any governance decisions

The Yearn Finance community brings people from all walks of life together and is one of the most active communities in the DeFi space. In addition, if approved by the community, select members can be added to the Yearn multisig, meaning, they have more executive powers within the community. The measure is only temporary to avoid abuses, but it's a great way to help the project build and grow.

And to simplify all the governance processes, Yearn has even set up a portal on Boardroom, a platform for managing Decentralized Autonomous Organizations (DAOs).

It’s difficult for DeFi projects to go mainstream, even if they are growing at a rapid rate within the decentralized finance community. The problem lies with the complexity of how liquidity mining works. Users are rewarded with new tokens every time they lend funds. The question is, will the average person ever really grasp this concept?

Once you look under the hood of a project like Yearn Finance and its YFI coin, you will see many complex operations which aren’t a part of traditional investments like index funds. And participating in the governing process, which is a big part of the project, requires voters to know the procedures and how changes may affect them directly.

It has to be said that Yearn Finance is still growing while providing benefits you don't get from a savings account. Bank depositors can only dream of such high yield on their deposits and complete decentralization. So in time, mainstreet may recognize the benefit of projects like Yearn Finance. What is now understandable only by a relatively small number of people may one day be common knowledge. Only time will tell.

Note: This is not financial or investment advice. Always do your own research before investing in any crypto asset or decentralized protocol. And please remember to trade responsibly and never invest more than you are willing to lose.

What is Yearn.finance (YFI) in 2023? What makes YFI a DeFi cryptocurrency?  Read our guide to Yearn.finance on 3Commas Blog.

All you need to know about Yearn Finance (YFI) in 2023 | 3Commas Blog

All you need to know about Yearn Finance (YFI)

Liquidity pools play a significant role in the formation of DeFi. They are crucial in automated market-making, borrowing/lending, yield farming, and many gaming projects. But what is a liquidity pools in crypto exactly?

This article explains the idea behind the liquidity pools concept, discusses how they work, and shares why major crypto projects leverage pools. Without further ado, let's have a look at how DeFi has refined the idea of liquidity pools.

In 2023, the concept of a liquidity pool remains fundamentally simple, yet increasingly vital in the rapidly evolving world of decentralized finance (DeFi). Essentially, a liquidity pool is a repository where market participants deposit their assets, creating a large reserve of liquidity to facilitate asset exchange. While in traditional financial systems, big banks serve as these liquidity pools—holding large deposits and even possessing the ability to create additional money—the crypto world offers a more decentralized approach.

A crypto liquidity pool consists of a cache of tokens securely locked in a designated smart contract account. Prominent decentralized exchanges (DEXs) rely on these liquidity pools to enable seamless trading activities. Although Bancor was one of the pioneers in introducing liquidity pools, it was Uniswap that truly popularized the concept. Another standout example in this context is Binance's liquidity solution, known as Binance Liquid Swap.

Fast forward to 2023, and liquidity pools have undergone further innovation, becoming integral parts of complex DeFi products and services. They are now often used in yield farming strategies, token swaps, and even in decentralized lending platforms. Newer blockchain projects are also adopting liquidity pools as a fundamental building block, recognizing their utility in providing depth and stability to the market. Given the expanding use-cases and the need for efficient asset exchange in the burgeoning crypto space, liquidity pools are expected to continue playing a pivotal role in the decentralized financial ecosystem.

A liquidity pool is token storage that provides trading a particular currency pair. Farmers provide liquidity in return for remuneration from the project, depending on the share they have invested. Reliable farming is provided by smart contracts (contracts based on software code), which act as digital agreements to fulfill the conditions of all parties. A liquidity pool is a smart contract filled with cash. 

Decentralized Exchanges (DEX) set orders to buy or sell crypto. The project's smart contract distributes a strictly defined amount of tokens to farmers, depending on their share of the investment. The model is called automated market-making (AMM).

So, if "X" invested $20,000 and "Y" invested the same pair, but at a rate of $10,000, then the total pool is $30,000. The share of the first — 66%, the second — 33%. The exchange allows farmers to buy and sell tokens within the pool at the expense of token liquidity. The higher the demand for the token, the more profitable deal farmers can grab. 

Most centralized exchanges (CEX) are based on a limited order book approach, just like traditional stock exchanges. They rely on market makers to adjust the price gap—the bid-ask spread for a limited order book.

Decentralized exchanges (DEX) typically use a liquidity pool mechanism; they have programmed an automatic market maker in a smart contract to provide balanced liquidity in the pool. DEX prefer liquidity pools, mainly because every time you place an order in a limited order book, there will be a gas charge on the Ethereum network. 

Frequently placing and canceling orders in the order book, just like on traditional exchanges, will significantly increase the commission per transaction for DEX users. However, by applying a liquidity pool, DEX investors can complete a transaction at a minimal cost.

Liquidity is the property of assets to be sold quickly and close to the market price.

Money is the most liquid asset, it’s common, and you can exchange it for any goods, services, or assets at any time. 

Market makers are organizations that facilitate trading by constantly buying or selling a particular asset, boosting liquidity. So users can trade without waiting for another counterparty to appear. The crypto exchange would be illiquid and unusable for users without market makers.

However, MM model is slow and expensive. Market makers usually keep track of the current value of an asset by constantly changing their prices. This leads to a huge number of orders and cancellations. There is a gas fee for every interaction with a smart contract on the Ethereum network, so market makers need a lot of money, constantly updating their orders. 

These and other reasons make exchanging assets using the "order book" model unviable. It was necessary to develop and implement a new working mechanism to ensure liquidity at the exchange. This problem was solved utilizing decentralized finance and liquidity pools.

A DeFi liquidity pool contains two tokens and thus creates a new market to exchange these assets. More often than not, liquidity pools crypto are provided in two tokens in a 50/50 ratio. One famous example is the DAI/ETH exchange market based on Uniswap. The user receives a portion of the commissions from all exchanges going through the pool by providing liquidity. 

When a new pool is created, the first liquidity provider sets a starting rate for exchanging assets within the pool. Each liquidity provider must deposit an equal amount of both tokens into the pool. Suppose the starting exchange rate within the pool is very different from current global prices. This immediately creates the possibility for arbitrage, which can mean a loss of capital for the liquidity provider. The concept of delivering tokens at the right ratio remains true for all subsequent providers who want to send their funds into the pool.

After sending tokens to the pool, the provider receives special tokens (LP tokens)  —  in proportion to how much liquidity they have provided. When a transaction in which the pool participates occurs, the decentralized exchange charges a commission of 0.3% of the transaction. It distributes that commission to all participants in the pool, in proportion to their share. Thus, there are earnings from the provision of liquidity. If a provider wants to get back the invested funds from the pool (along with the accrued income), they must conduct a burn of their LP tokens.

Using the liquidity pool, each exchange of tokens causes the exchange rate to move according to a unique algorithm. This mechanism is also called Automatic Market Maker (AMM), and liquidity pools of different protocols may use slightly different algorithms.

Basic lp pool, such as Uniswap's, use a constant, calculated as the product of the number of both tokens in the pool. That way, the pool can always provide liquidity. Simply, the fewer tokens A remains, the more expensive they become, and the cheaper tokens B become. 

It turns out that if a user buys a lot of ETH in an ETH/DAI pair, user reduces the ETH stock and increases the DAI stock, which is immediately reflected in the exchange rate. The larger the pool volume relative to the transaction size, the less this transaction affects the price.

Larger pools of liquidity create a more stable environment where each transaction has almost no effect on the shift in the exchange rate. This is the ultimate goal of both market participants and liquidity providers (they make money on commissions from transactions, more transactions mean more income). 

Liquidity mining pools are the reason why protocols such as Balancer motivate liquidity providers to invest their tokens in certain small pools. This process is called liquidity mining. The idea is simple enough. Still, it’s tricky within the world of trading and exchanges, as it allows to refuse order books and market makers, distributing revenue from trading activity among all pool participants.

The Uniswap protocol pools we've just described are a basic type of pool. Other open-source projects have continued to work on this technology and have proposed new pooling schemes.

For example, Curve was the first to realize that the mechanism offered by Uniswap was not well suited for exchanging assets whose price should not change, depending on supply or demand. That's because they are backed by real assets, like the U.S. dollar. This type of asset, in particular, includes stabelcoins such as USDT, TUSD, USDC, and others. Curve pools work on a modified algorithm that reduces sensitivity to each transaction, and the exchange rate remains more stable.

Another idea for developing liquidity pools crypto came from the Balancer protocol: the creators of the project realized that developers should not limit themselves to a pair of tokens in a pool, so Balancer allows up to 8 tokens within one pool.

However, the interest per annum in DeFi is not constant and depends on many factors. First of all, the interest depends on the size of the liquidity pool itself  —  as the pool increases, the interest per annum will fall.

Independence from centralized exchanges, third parties, and no account verification (KYC)

DeFi functions on smart contracts, which means no one can stop interacting with them.

It involves constant analysis of new pools, platforms, and redistribution of funds between them, so the skills learned can come in handy many times in the future.

Potentially big profits entail potentially big risks. In addition to the standard DeFi risks, such as smart contract bugs, system risks, and admins' keys, investors and traders get two new types of risks  —  impermanent loss and liquidity pool hacks. 

A DeFi investor's funds are locked into the pool's smart contract and are not on the exchange. This means that the investor will not use classic exchange functionality and order system, so he will not set stop-losses and take-profits.

Despite the perceived danger, a much smaller disadvantage of participating in DeFi is the Impermanent Loss phenomenon. This concept refers to the difference in asset value when simply holding in a wallet versus participating in a liquidity pools crypto. 

Not sure what impermanent losses are? Check out our thorough guide about impermanent losses.

In most cases, the impermanent loss is not a significant factor, and if there is enough time to participate in the pool, it’s compensated by the rewards. However, the impermanent loss may increase significantly. 

Smart contracts also involve higher risks. Namely, risks associated with interacting with a fraudulent smart contract due to negligence and the risk of hacking the pool smart contract itself by attackers. No one is immune to the latter, and in the event of hacking, you stand to lose your money completely.

The idea of liquidity pools and mining is straightforward. At the same time, it completely changes the world of crypto-trading and the work of exchanges, as it allows to abandon the traditional order book, distributing traders' commissions among pool members.

What Are Liquidity Pools in DeFi and How Do They Work in 2023?

What Are Liquidity Pools in DeFi and How Do They Work?

Did you hear about eye-popping yields, sometimes more than 1,000% APY? That’s partially due to AMMs. But what does AMM stand for? AMM or Automated Market Making, plays a big role within the Decentralized Finance because AMMs use liquidity pools to make the DeFi ecosystem liquid 24 hours a day, seven days a week. Rather than depending on conventional buyers and sellers in a crypto market, AMMs bring stability to the table. 

Automated Market Maker (AMM) is a DeFI exchange protocol. Basically, it’s a market-making bot using a mathematical algorithm to establish a price for a specific crypto pair. 

Instead of relying on order books — as traditional exchanges do — AMM uses mathematical formulas, that may differ across AMM protocols. Traditional market making is a viable choice for firms that trade huge volumes as it quotes the best price and most favorable bid-ask spread on exchanges with order books. However, the decentralized nature of AMM protocols unlocks the opportunity of creating new or contributing to existing markets to any user.

Usually, an exchange protocol utilizes a unique formula for calculating the price of the assets in the liquidity pool. In addition, there are some differences in functionality.

Some of the existing AMM protocols are listed below.

One of the most prominent AMM on the market. Absent listing fees, no capital requirements for participants, and low gas fees are the main advantages of the protocol. 

Moreover, Uniswap V2 supports an ERC-20/ERC-20 token pair. UNI is a native AMM coin of this protocol, which gives its holders governance rights.

The supply of the tokens is adjusted according to the constant mean market maker formula (CMMM). It allows creating private liquidity pools with up to 8 different tokens and the custom ratio between assets. Moreover, Balancer features dynamic transaction fees. 

It’s a reliable AMM in terms of Total Value Locked  — more thatn 2B dollars are locked inside the protocol, meaning that no-one can withdraw them instantly. 

A distinctive feature of this AMM model is that not everyone can access the liquidity pool as it requires substantial capital investments. External oracles or parameters of the smart contracts set price on the tokens here, which guarantees increased control of the pool for the market makers, even when the prices fluctuate.

The protocol lost most of the funds recently. Now it’s not as reliable as it once was. 

The pricing mechanism of this protocol relies on the combination of constant product and constant sum formulas. According to it, it’s possible to decrease the risks of slippage and impermanent loss if the underlying assets have stable prices. However, Curve is designed specifically for stablecoins.

Some of the protocols also have forks. Both SushiSwap and QuickSwap are the hard forks of Uniswap. They operate on the audited code of Uniswap but offer additional features. For instance, QuickSwap allows trading ERC-20 tokens through the Polygon network bridge, which solves the issues with higher fees of Uniswap that occur during increased network activity. Both protocols also have their native tokens (QUICK and SUSHI) that provide governance rights to the liquidity providers that hold them.

With more than 15B dollars locked, the protocol has a substantial turnover and credibility. 

How do AMM models of exchange protocols operate?

Trading mechanism of both traditional and DeFI exchange networks relies on pairs of assets. However, with Binance market maker bot and other traditional exchanges, the trade deal can’t happen without a counterparty, meaning that the transactions occur between users’ wallets. This is peer-to-peer (P2P) trade. If you are selling a particular asset, there is always an opposite side that is purchasing it and vice versa.

On the other hand, operations on Automated Market Maker exchanges are peer-to-contract (P2C). Thus, trades happen between users and smart contracts, without counterparties. The price of assets in the AMM pool is calculated using a formula. Let’s take a look at the most common algorithms that these protocols use while establishing prices on assets.

Constant product is represented by the following equation: X * Y = K 

X and Y stand for the coins in a crypto pair, while K is a constant liquidity value. According to this formula, the increased supply of the token X causes the decrease in the supply of token “y”. This happens because the value of total liquidity doesn’t change. 

The main drawbacks that come with using this algorithm are the high volatility of prices and the risk of impermanent loss for the liquidity providers. Uniswap is the protocol that uses this formula for calculating the prices of the tokens in the pools. It also serves as a basis for other algorithms, described further.

Constant sum market maker (CSMM) is a variation of the CPMM formula: X + Y = K. The concept remains the same; even if the value of X and Y variables changes, the total value of the liquidity, represented by their sum, is constant. The proportion of the supply of tokens in the pool determines their price.

The CMMM market maker estimates the mean value for every coin, which is basically its weight. Imagine a liquidity pool consisting of four locked coins, the equation that represents the algorithm would be the following.

Variables X,Y, Z, and K stand for the assets, while C represents a constant value of their product. The equation changes depending on the number of tokens in the liquidity pool.

AMM crypto exchange protocols that use the CMMM formula allow including multiple assets to a single liquidity pool. On platforms that use CMMM, users have the ability to create custom pools, where the ratio between the locked tokens is unequal. However, the value doesn’t change as long as reserves of weighted assets are constant. This is possible because the equation factors in the weight of each token, instead of the total product. Balancer is one of the AMM protocols that use this CMMM formula in the pricing mechanism.

Virtual constant product is represented by the following equation

X and Y are reserves of particular tokens, variable A is the number of tokens user deposits to the reserve Y

Z is the value on which reserve X decreases after the user supplies A. Spread is always a percentage, which depends on the governance system of the particular protocol.

This adapted virtual market-making algorithm unlocks the possibility of making profit from deals on derivatives. In this case, the formula is the core of the pricing mechanism. In fact, it is based on the classic CPMM function with some additional variables. Its main benefit is that it eliminates the risk of impermanent loss. Moreover, the network doesn’t need liquidity providers as traders fill the pools themselves by providing money to the vault. One of the protocols that use this formula is Perpetual.

AMM protocols have to attract market makers in order to increase liquidity of assets and eliminate the effect of slippage with big orders. The more liquidity is in the pool of the exchange protocol, the bigger deals its traders can potentially make. 

Since it’s only possible to trade on the AMM exchange because there are liquidity pools, the main goal of market makers is to provide liquidity. Market makers are the users that contribute to existing pools or initialize new ones by depositing certain pairs of tokens. 

The rule of thumb to become a market maker is locking some amount of various tokens into a liquidity pool. Conditions may vary depending on the protocol. For instance, QuickSwap LPs have to provide an equivalent value of a pair of coins to the pool. Some protocols can combine more than a pair of assets, so the ratio would be different. 

The main motivation to become a market maker is the rewards that platforms payout to their liquidity providers. QuickSwap LPs can earn 0.3% transaction fees for every trade in the pool they contributed liquidity to. Again, the reward system is also unique to each protocol.

In 2023, AMM (Automated Market Maker) protocols have redefined the landscape, turning every user into a potential crypto market maker, a defining characteristic of modern DeFi. Interestingly, certain networks even allow for the initiation of liquidity pools without demanding significant capital outlays. Diverging from traditional exchange practices, AMM platforms harness mathematical algorithms rather than order books for asset pricing. While the specific algorithms vary among protocols, they uniformly operate on a peer-to-contract transaction basis. AMM protocols, while transformative for the current DeFi ecosystem, still have room to grow in terms of functionality when juxtaposed with conventional exchanges. Yet, the horizon for their evolution looks exceptionally promising.

What Is an Automated Market Maker (AMM) 2023

It is one of the few emerging decentralized cryptocurrency exchanges (DEX) that operate on the Ethereum blockchain and facilitate token swaps. Before we further explore Uniswap along with Uniswap token, let's first understand the problem it is attempting to solve.

An overwhelming majority of cryptocurrency investment and trading is done through centralized exchanges like Binance or Coinbase. These services are owned and operated by a single organization which yields all the power. As a user, you are required to deposit and store your funds under a single entity's control which relies on a conventional order book for trading digital assets.

Order book system is where trade orders are accumulated and presented in a list that also includes the total amount of each order. The number of open trade orders for a particular cryptocurrency is referred to as 'market depth'. For a successful trade to occur through the order book system, every buy order must have a corresponding sell order featuring the same price and the amount of the digital currency. 

The primary issue with the order book system is its liquidity. It means that at any given point, there might not be enough market depth i.e. the number of trade orders to fulfil every buy and sell order. This results in a poor trading experience as users fail to complete their buy and sell orders.

As mentioned in the introduction, Uniswap is a unique type of cryptocurrency exchange that is completely decentralized. It means that it is not owned and governed by a single organization. Built in 2018 on top of the Ethereum network, the exchange relies on a new trading model known as automated liquidity protocol. Since the exchange uses the Ethereum blockchain, it ensures compatibility with all ERC-20 coins as well as software applications including wallets.

One of the major advantages of Uniswap is that it is an open-source project so anyone can use the code to build their own decentralized crypto exchange. It enables users to list cryptocurrencies on the exchange at no cost which is completely opposite to centralized exchanges that are business-oriented and success-driven. They charge a high commission fee to list new tokens on their exchange. 

Since Uniswap is a decentralized exchange or DEX, it means that traders can exercise complete control over their funds at all times and don't have to give up their private keys which are used to log orders on the centralized exchange's internal database. By having control over private keys, Uniswap reduces the risk of losing your digital assets if the exchange becomes a victim of a security breach. Currently, Uniswap v2 is the fourth largest decentralized finance (DeFi) exchange with more than $3 billion in crypto coins.

Just like any other blockchain, Uniswap also has a native token which is denoted by the initials of UNI and is used for governance primarily. Those who are holding UNI tokens have the right to vote on changes and new developments on the platform including how newly minted tokens should be distributed among the developers and community members along with changes to how the transaction charges are structured. The UNI token was officially launched in September 2020 to prevent users from opting for competing for decentralized exchanges. 

At genesis, 1 billion UNI tokens were minted out of which 60% have been distributed among the existing Uniswap community members while 40% will be distributed among multiple stakeholders including investors, advisors, and team members over a period of 4 years. A portion of community distribution occurs through liquidity mining which means that UNI is given to those who provide liquidity to a wide range of pools including the following.

The Role of Automated Liquidity Protocol in 2023

As we move through 2023, Uniswap's reliance on its automated liquidity protocol continues to offer a robust solution to the liquidity challenges that often beset centralized exchanges. This mechanism gains its efficiency by motivating users of the DEX to become liquidity providers (LPs). In this system, LPs collectively pool their digital assets, forming a consolidated fund designed to handle all buy and sell trades occurring on the platform. Every cryptocurrency available for trading possesses its distinct pool, allowing users the choice to contribute.

The beauty of the automated liquidity protocol is that it eliminates the necessity for both buyers and sellers to wait for a matching counter-order. If the specific cryptocurrency pool they're targeting boasts ample liquidity, their order will be instantly processed at a preset price. LPs, having invested their resources into the pools, receive tokens mirroring their contribution. To illustrate, a $5,000 investment in an automated liquidity pool with a total of $100,000 grants you a token symbolizing 5% of that pool. This token can later be redeemed to claim a proportionate slice of the trading fees.

In terms of fees, Uniswap implements a consistent 0.30% charge on every transaction executed on its decentralized platform, redirecting it to the relevant liquidity pool. When LPs opt to withdraw, they obtain a fraction of the entire pool fees, mirroring their staked sum. Subsequently, the token representing their stake is nullified. Notably, the Uniswap v2 update introduced a discretionary protocol fee, which can be toggled on or off based on community consensus. This fee takes 0.05% from each transaction, funneling it into a Uniswap development fund to propel future advancements.

Since decentralized exchanges don't use the order book system, there is an alternative system used to determine the price of each digital asset. It should be kept in mind that while the order book system matches the lowest seller with the highest buyer, Uniswap relies on an automated market maker protocol. This alternative system adjusts the price of digital coins based on their supply and demand which is determined through a mathematical equation. The equation works by increasing and decreasing the price of a particular digital asset based on the percentage of the coins present in its respective pool.  

It is important to bear in mind that when a user adds a new ERC-20 token to the platform, they are not only required to add a particular amount of their selected ERC-20 token but an identical amount of another ERC-20 token as well to start the automated liquidity pool. The equation that determines the price of the coin is x*y=k, where the amount of the first ERC-20 token is x and the amount of the second ERC-20 token is y. K remains a constant which means its value doesn't change.

For instance, John wants to trade Bitcoin (BTC) for Ripple (XRP) relying on the Uniswap BTC/XRP pool. Now, John will add a large amount of BTC to the pool which will increase the share of BTC in the pool to XRP. Since K is constant, it means the price of XRP will increase while the price of BTC in the pool will decrease. So the more BTC John puts in, the less XRP he gets in exchange because the price of XRP will continue to increase. Another factor that affects the price change is the size of the liquidity pool. The more liquidity there is in a pool, the simpler it is to execute large orders without affecting the price as much.

Arbitrage traders are an important part of the Uniswap platform. These are the trades that find price discrepancies across a number of exchanges and capitalize on the opportunity to pocket a positive result. For instance, if Ethereum was trading on Coinbase for $2,000 and Kraken at $2,050, you can buy Ethereum on Coinbase and sell it on Kraken to make an easy success. If arbitrage trading is done in large volumes, traders can secure a substantial success without taking too much risk.

Arbitrage traders on Uniswap try to find cryptocurrencies that are trading below or above their market price because of large trades that generate asymmetry in the pool leading to price surge or reduction. Then they buy or sell such coins to be successful. What arbitrage traders do is bring the token price to its market price by buying or selling until the price aligns with the market price. This particular phenomenon involving arbitrage traders and an automated market maker system is what keeps Uniswap token prices aligned with the rest of the cryptocurrency exchanges.

Using Uniswap is comparatively easy and straightforward. You will need to set up an ERC-20 supported wallet such as Coinbase wallet, Fortmatic, Portis, WalletConnect, or MetaMask. 

After you have set up one of the ERC-20 wallets, you need to transfer ETH tokens to it that will allow you to start trading on Uniswap and pay for gas (Ethereum transaction fees). Gas payments change from time to time in terms of price and they are usually based on the number of people using the network. 

The majority of ERC-20 compatible wallets give you the options to choose the speed of paying through the Ethereum blockchain including slow, medium or fast. The slow option is the cheapest option while fast will set you back a substantial sum. On the other hand, the medium is somewhere in between the two. This will determine at what speed your transaction is completed by Ethereum network miners.

Step 1 - Go to the official website https://www.uniswap.org.

Step 2 - In the top right corner, you will see the "Use Uniswap" button. Click on that button.

Step 3 - Once again in the top right corner, you will see "Connect Wallet". Use this button to select your wallet.

Step 4 - Now log into your cryptocurrency wallet and let it connect to the Uniswap platform.

Step 5 - After the wallet is connected, you will see an option to swap tokens directly. You can use the drop-down list next to the “to” and “from” sections.

Step 6 - Now you can select the digital coin you want to swap. Enter the amount you'd like to exchange and click "swap".

Step 7 - You will be presented with a preview screen so you can ensure all the details are correct. Once you are sure, confirm the transaction.

Step 8 - Now you will need to wait for the transaction to be processed and added to the Ethereum blockchain.

As a project, Uniswap does not make any money. It is a decentralized exchange protocol operated by Paradigm which is a cryptocurrency hedge fund. All transactional costs go to liquidity providers who can claim them at any time. Founders of the project don't get any cut from the transaction fees. As of now, the transaction fee that is paid to LPs is 0.30% for every trade.

The fee is added to the liquidity pool automatically which can be redeemed by the LPs anytime they want. The fees distributed among LPs is proportional to their stake in the respective pool. In Uniswap v2, a percentage of fees may be deducted for Uniswap development.

In 2023, as the cryptocurrency landscape has matured, conventional exchanges, while acting as pillars supporting cryptocurrency investments and trading internationally, have also unintentionally spotlighted the significant issue of centralization. These platforms wield absolute dominion over users' digital assets, a centralized control that many in the crypto community view with skepticism. Uniswap, seizing upon this concern, provides a solution in the form of a decentralized exchange. Here, trades are not facilitated via a traditional order book but are navigated through an automated liquidity protocol. This approach decentralizes power since the protocol operates based on contributions from a myriad of liquidity providers (LPs), ensuring no singular entity or institution maintains overarching control.

By 2023, Uniswap's trajectory has been nothing short of impressive. While once in its nascent stages, it now ranks as the fourth-largest decentralized exchange, boasting an impressive average daily trade volume of $2 billion. The crypto community, traders, and investors alike are eagerly watching how the project's founders and contributors capitalize on their current momentum and steer Uniswap's future course.

Do you know what is Uniswap in 2023? 3Commas Blog tell you it's one of the few emerging DEX that operate on the Ethereum blockchain and facilitate token swaps.

What is Uniswap and How Does It Work in 2023? | 3Commas Blog

In 2023, the DeFi landscape has evolved considerably, with platforms like Uniswap, SushiSwap, and PancakeSwap emerging as dominant players. These platforms democratize finance, enabling virtually anyone to step into the shoes of a market maker. By pooling their assets into shared liquidity reservoirs, individuals can earn commissions. The beauty of this system lies in its simplicity: it offers a pathway to passive income without demanding specialized knowledge, hefty investments, or advanced equipment.

However, venturing into the DeFi space isn't devoid of potential pitfalls. One notable concern is "Impermanent Loss" — a transient financial setback that liquidity providers on decentralized platforms might grapple with. This stems from the occasional disparity in crypto asset values across decentralized exchanges (DEXs) and their centralized counterparts (CEXs). To illustrate, while BTC might be trading at $60,000 on UniSwap, it could command a $61,000 price tag on Binance.

Let's contextualize this with a real-world analogy. Imagine purchasing an apartment in a quaint town for $400,000 in 2020. That same year, a Bitcoin was valued at $40,000. Essentially, your apartment's worth could have fetched you ten Bitcoins. Fast forward to 2021, those ten Bitcoins would have been worth $630,000. This indicates an "impermanent loss" of $230,000. While you haven't experienced a tangible loss, you've missed out on a potential gain of that amount.

Over time, prices tend to find equilibrium. Nonetheless, every scenario has its nuances. Should a market-maker opt for an untimely fund withdrawal amidst volatile market conditions, they might incur losses.

Impermanent loss occurs when you provide liquidity to the liquidity pool, and the price of your deposited assets differs compared to when you deposited them. The greater this change, the more you are exposed to an impermanent loss. In this case, the loss means less value in dollars at the time of withdrawal than at the time of deposit.

Pools containing assets that remain in a relatively small price range will be less prone to impermanent losses. For example, stablecoins or different versions of coins will remain in a rather limited price range. In this case, there is less risk of volatile losses for liquidity providers (LPs).

So why are liquidity providers still providing liquidity if they are subject to potential losses? 

Uniswap charges 0.3% on every trade that goes directly to liquidity providers. If a given pool has a high volume of trades, it may be profitable to provide liquidity, even if the pool is highly exposed to volatile losses. However, this depends on the protocol, specific pool, deposited assets, and even broader market conditions.

Trading commissions can still counteract impermanent losses. Even pools on Uniswap, which are very prone to volatile losses, can be profitable thanks to trading commissions and AMM mechanisms.

According to a definition, AMMs are autonomous, decentralized exchanges managed by software. A basic algorithm controls the prices of the assets stored in AMM liquidity pools. Liquidity is provided by liquidity providers (LPs), who usually contribute equal amounts of two assets per pool. For example, ETH and DAI.

AMM was first described on Reddit by Ethereum platform founder Vitalik Buterin  —  as a way to simplify market making on smart contracts. A year later, in 2017, the first AMM Bancor appeared, and another year later, Uniswap appeared, which is now the market leader. 

Using automated exchanges, investors can deposit their coins into liquidity pools and, in return, receive rewards (in the form of commissions charged to traders), which are calculated in proportion to their investment shares. Typically, LPs are also rewarded with project tokens, which entitle them to vote on key protocol changes.

Thus, liquidity providers are interested in placing their assets in AMM because they are rewarded in commissions from traders and project tokens. However, they may face an Impermanent loss, which is a significant risk to their income.

People often misunderstand Impermanent loss (IL). Commissions, spreads, slippage, even block time are usually attached to its calculations. But none of this affects the IL in any way. The IL is a formula with a known result, which does not depend on the above.

Impermanent loss is a price you pay by using one investment strategy instead of another. The difference between using a "constant proportion strategy" and a "buy and hold" strategy. However, IL assumes that you will only keep the assets in your wallet if you don't supply liquidity to the AMM. But this is an incorrect assumption. People can and will make a million investment decisions, make trades, etc.

If you calculate IL every time you make one decision instead of another, any action will carry IL technically. Imagine you bought a laptop for $10k back in 2019. If you purchased ETH instead, you would now have $40k. You have an Impermanent Loss of $30k

AMM protocols are governed by a mathematical algorithm that automatically balances the ratio of assets in the pool at the 50:50 level and thus determines their value. The pricing mechanism uses the formula: X*Y = K, where X and Y are two different assets, and K is a constant value, which must be the same before and after the transaction.

This algorithm allows the market to function autonomously, creates the possibility for arbitrage, but is also the cause of variable losses in DeFi. The fundamental cause of impermanent loss is a mismatch between the value of coins in the liquidity pool and the actual market situation.

Impermanent losses occur when the value of one asset changes relative to another and result in an unrealized gain for the investor. But how big of a loss can be incurred compared to HODLing? (buy and hold) It all depends on how much the price has changed, meaning that the more price changes, the more your losses will be:

You can also use an impermanent loss calculator to understand what are the losses.

Suppose the liquidity pool has two digital assets ETH and DAI. To provide 50/50 liquidity to the pool, the LP must provide the pool of assets at equal value. For example, 1 ETH = 4,100 DAI. A user, for example, deposits 1 ETH and 4,100 DAI, and since the value of a DAI is fixed at $1, the investment is equal to  $8,200.

Now let's imagine that this is 10% of the total pool. That is, Constant K = 10 ETH x 41000 DAI = 410,000. And after all the transactions in the pool, it must remain true.

As long as the total value of both tokens is the same, everything is stable. When the value of ETH begins to rise, arbitrage traders will come into play. They buy ETH out of the pool at a lower value than the market value until it compares to the outside price. The pool ratio must stay the same at 410,000.

If an investor who originally invested 1 ETH = 4,100 DAI, at some point withdraws funds, he will receive 0.5 ETH and 2,050 DAI. If the investor had preferred the HODL strategy to escrow, the value of his assets after the rise in the price of Etherium would have been more favorable, say $4,300. 

The difference between $4,300 and $4,100 (0.5 ETH = 2050; 2050 DAI = 2050 USD) is impermanent loss. 

In an ideal market without high volatility and constant ups and downs, liquidity providers on exchanges with AMM would simply make a profit on commissions. For example, at Uniswap LP, they receive 0.3% of all commission charged from traders, distributed proportionally to their shares in the pool. Many protocols also have programs to reward liquidity providers with their tokens.

But the cryptocurrency market is highly volatile, and it’s not always possible to predict fluctuations in value. Even in the case of stabelcoins tied to traditional assets, there is still some volatility. The risk of a volatile loss in such an environment is relatively high.

However, this doesn’t stop investors from maintaining DeFi liquidity pools, and there are several reasons for this. First, despite the term "volatile loss" being specific to AMMs only, there are similar phenomena on regular exchanges and the stock market. For example, on centralized stock exchanges, traders suffer losses when the whole market moves aggressively in one direction because they mostly hold positions on both the bid and the ask.

The second thing that makes one continue to invest in liquidity pools is the remuneration. LPs are guaranteed a set percentage of all trades completed on the platform. That said, the more trades and the higher the share in the pool, the higher the potential return. Most of the time, successful traders earn more, the rewards cover possible losses.

Finally, investing in DeFi liquidity pools is an easy and passive way to make money. Minimum capital requirements are low; there is no need to constantly analyze the market, spend time on opening and closing positions, as it happens in trading.

In addition, the term impermanent losses describes the temporary nature of the phenomenon. Losses can only become real if the investor decides to withdraw his deposit from the liquidity pool. Usually, if you wait, the price ratio will return to its previous value.

Once you understand what does impermanence mean, it’s time to prevent the losses. 

One of the easiest and most effective ways to mitigate intermittent losses is maintaining liquidity in pairs with low volatility. Above all, preference should be given to older and more significant projects that already have their price formed and are less volatile. These include cryptocurrencies from the Top 20 by capitalization.

Second, you have to choose pairs where the value of one asset relative to another remains relatively stable. For example, it can be paired with stabelcoins. Another thing is that this kind of investment option is limited in terms of potential price growth.

Some special tools and platforms allow liquidity providers to mitigate volatile losses. For example, the AMM Balancer protocol allows customization of individual proportions for liquidity pools with different pairs. In this way, liquidity providers can anticipate market movements and reduce their potential volatile losses if asset values move as they have planned.

You can also use the open-source Hummingbot. The specialized bot allows you to start investing in Binance liquidity pools with minimal effort and fully automated, keeps track of centralized order books, and avoids volatile losses.

It's best to start investing in AMM in small amounts. Especially if you are just getting familiar with the market or trading pair, small investments help to evaluate with minimum risk which way the price can move and what real losses can be incurred.

Make sure to find a reliable, proven AMM platform as well. The DeFi sphere is now at the peak of popularity, and anyone can fork an existing project by adding only minor changes to it if they want to. This can cause errors in the protocol and lead to not temporary but quite actual losses.

Impermanent Loss is one of the main terms that liquidity providers should be familiar with. Many of the most popular AMMs, such as Uniswap, PancakeSwap, and others, have emphasized usability and simplicity without providing any mechanism to prevent liquidity pool impermanent loss. Therefore, investors should understand what LPs are, how losses are generated and avoid potential losses.

Here is what you can do to prevent losses dealing with DeFi projects.

Supply liquidity to pools with unequal asset ratio

Supply liquidity to one-way stacking pools

Supply liquidity to pools with tokens tied to a single asset