With the recent private releases of the UNIT networking token, liquidity pools will play an essential part in stabilizing and providing orderly price discovery to the token. This is done by helping with automating the markets while paying out to those involved in staking their tokens. This rather short, non-technical guide will attempt to explain the automated market making systems available in DeFi in simple terms before navigating you through the process needed to stake UNIT in our liquidity pool.
First of all, some of you may be asking what on earth a liquidity pool is. To understand this, we need to explore how automated market makers execute the buy and sell orders for any transaction on the blockchain. Simply put, market makers are in place to facilitate the processing of buy and sell orders of a token as quickly as possible. The sum of all the different orders to buy and sell is called the order book. At times these buyers and sellers may not agree on a price so the market makers step in to facilitate a market clearing price for transactions. This whole process is automated on the blockchain and executed by algorithms that set prices based on market flows and available liquidity. They are extremely efficient at processing their tasks but do have limits with respect to how much they can step in to facilitate transactions. This is because the more they execute transactions the more risk they run; the amount of risk they can run is a function of the capital they have available to put at risk. The more capital they have the more they can facilitate an orderly market place. In extremis, if a transaction is too large then it may get referred to an “upstairs” market maker for big block trades – just as in ordinary stock trading.
Now that we have a basic understanding of a liquidity pool’s purpose in the market, we need to gain a brief understanding of how one works. Liquidity pools are nothing more than smart contract interactions at the token level. They are code written in a certain way to hold specific assets and perform mathematical operations in order to balance liquidity. To get a little more technical, the pool starts off with a balanced ratio of 50:50 in the assets that it contains. As the user buys or sells more and more of one of these specific assets, this ratio changes and the price at which subsequent transactions can be entertained changes due to the imbalance in the pool. Ultimately, the pool wants to keep this initial 50:50 ratio in order to continue providing liquidity to the market and therefore adjusts the prices of assets accordingly to maintain this 50:50 ratio as part of each transaction.
Liquidity pools can also be daisy chained to allow for direct token-token exchanges by linking pools with the same base currency (ETH as an example) which is seen quite clearly on Uniswap and Pancakeswap transactions.
The liquidity found in assets as part of a liquidity pool must come from somewhere in the first place and this is where the stakeholders and average users come into play. Since liquidity pools need large amounts of cash flowing through them to stabilize and enhance price discovery, large crowdsourcing of risk capital has become the answer!
As a stakeholder of a token in a pool (Let’s say the UNIT to USDU pool), you are providing the market makers with risk capital needed in order to facilitate and automate transactions and enhance price discovery both of which must contribute to stabilize the market for a token which in turn must enhance the token value proposition. In addition to this positive aspect, every transaction executed earns a fee most of which goes to the liquidity providers and market makers (eg. Uniswap). Thus, pool providers do earn a return on the tokens they have staked as risk capital in the liquidity pools.
I hope this short guide has helped give you an insight into how these tools all help grow markets. Perhaps this further understanding of how markets are made and liquidity provided will impart you with the confidence to help us stabilize and scale the $UNIT token with your help!