“The world of finance runs on liquidity. Without available funds, financial systems grind to a halt. DeFi, or decentralized finance—a catch-all term for financial services and products on the blockchain—is no different. DeFi activities such as lending, borrowing, or token-swapping rely on smart contracts—pieces of self-executing codes. Users of DeFi protocols ‘lock’ crypto assets into these contracts, called liquidity pools, so others can use them” [Genc, E. What Are Liquidity Pools? The Funds That Keep DeFi Running. (Accessed October 23, 2022)].
In its basic form, a single liquidity pool holds 2 tokens and each pool creates a new market for that particular pair of tokens. When a new pool is created, the first liquidity provider is the one that sets the initial price of the assets in the pool. The liquidity provider is incentivised to supply an equal value of both tokens to the pool. If the initial price of the tokens in the pool diverges from the current global market price, it creates an instant arbitrage opportunity that can result in lost capital for the liquidity provider. This concept of supplying tokens in a correct ratio remains the same for all the other liquidity providers that are willing to add more funds to the pool later.
[Jakub. How Do Liquidity Pools Work? DeFi Explained. (Accessed October 23, 2022)].
“Unfortunately, while liquidity providers earn an income via fees, they’re exposed to impermanent loss if the price of their deposited assets changes” [Clarke, A. What directional liquidity pooling brings to DeFi. (Accessed October 23, 2022)]. “Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit […] It’s called impermanent loss because the losses only become realized once you withdraw your coins from the liquidity pool. At that point, however, the losses very much become permanent.” [Binance Academy. Impermanent Loss Explained. (Accessed October 23, 2022)].
While it is very true that the effects of impermanent loss may be mitigated or even reversed through the collection and distribution of trading fees, yet another new DeFi innovation has presented itself as a tool to avoid impermanent loss. “Maverick AMM introduces the novel AMM concept of Directional LPing, which facilitates better capital control for liquidity providers and offers massive improvements in capital efficiency” [Maverick Protocol. Maverick AMM: The Revolutionary AMM That Enables Directional LPing, Unlocking Greater Capital Control and Higher Capital Efficiency. (Accessed October 23, 2022)].
When LPing in any existing AMM in the DeFi universe, the LP is making an implicit bet that the price of the pair of assets in their pool will go sideways, enabling them to collect trading fees without the ratio of their deposited assets shifting significantly. If that bet is wrong–that is, if the price moves in any direction other than sideways–the LP will suffer impermanent loss that may exceed their fee income. This is a huge limitation within the current AMM landscape, as many asset holders who would like to LP have a directional belief about the assets they hold. For example, if a user is bullish ETH, there is no existing LPing option that allows them to make a simple bet that the price of ETH will go up and collect trading fees from that bet. This mismatch between price belief and the tools available to bet that price belief leaves the DeFi ecosystem with thin markets and bad pricing. Maverick changes this dynamic. By allowing LPs to pick a direction and earn excess returns if they picked correctly, Maverick opens LPing to a whole new class of market participants. (emphasis added)
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Directional liquidity pooling lets liquidity providers stake a range and choose how the liquidity should move as the price moves. In addition, the AMM smart contract automatically changes liquidity with each swap, so liquidity providers can keep their money working no matter the price. Liquidity providers can choose to have the automated market maker move their liquidity based on the price changes of their pooled assets. There are four different modes in total:
- Static: Like traditional liquidity pools, the liquidity does not move.
- Right: Liquidity moves right as the price increases and does not move as the price decreases (bullish expectation on price movement).
- Left: Liquidity moves left as the price decreases and does not move as the price increases (bearish expectation on price movement).
- Both: Liquidity moves in both price directions.
[Clarke, supra].
In order to stake Mode Right or Mode Left, the LP is generally expected to add liquidity to the bin immediately to the left or the right of the current active bin, respectively. So an LP using Mode Right to make a bullish bet would stake the bin immediately to the left of the active bin, and vice versa. Assuming their bet is correct, as the price swaps past the edge of the active bin, that bin will go from being a mix of both assets to holding only one asset: either all base token or all quote token. In this state, the liquidity in that bin can be moved freely to a new bin that is closer to the price or intermingled with other single-asset bins, such as the LP’s. Continuing with the Mode Right example, a bullish LP would stake the bin immediately to the left of the active bin, meaning that their stake would consist entirely of quote asset at the outset. Assuming their bet is correct and the value of the base asset goes up, traders would swap base asset out of the active bin until there is none remaining, moving the price to the right and thus past the edge of that bin and into the next bin. At this point, the AMM can reconcentrate the LP’s stake into the formerly active bin, since both are now composed entirely of quote asset. All this liquidity–including the LP’s–now sits in the bin directly to the left of the active bin, and can collect fees whenever price volatility moves the price left into this bin again. This process of reconcentration will repeat as long as the LP remains staked and the price continues to move right through the bins in the pool.
[Maverick Protocol, supra].
“Essentially, directional liquidity pooling allows liquidity providers to manage their liquidity based on their expectations of the asset’s price performance. If a liquidity provider expects an asset to appreciate, they can choose to have their liquidity move the right and earn additional fees if correct and vice versa” [Mangalindan, G. What is Directional Liquidity Pooling? The New AMM Explained. (Accessed October 23, 2022)].
“Unlike other range AMMs, the fee collected by a position in Maverick compounds back into the bin where it was collected. In other AMMs like Uniswap v3, the fee is held out separate from the liquidity in the pool and is not earning fees. In Maverick this fee income is auto-revinested, thereby increasing capital efficiency while saving the LP gas fees. The fee reinvestment and position tracking mechanisms are similar to constant product AMM designs, except each bin has its own LP balance and fee accumulation” [Maverick Protocol, supra].
“Directional liquidity pooling is an emerging method for liquidity providers to add liquidity to decentralized exchanges while optimizing their returns and guarding against impermanent loss. By assigning their liquidity to move in the direction of the asset’s price, they can earn additional fees and avoid having to adjust their deposited liquidity if an asset price moves up or down” [Mangalindan, supra].
