Riding the DeFi hype, Uniswap Liquidity Pool proposal

Main Published on: Sep 18, 2020 Last updated: Sep 18, 2020

LTO Network is proposing to add more liquidity into the ETH/LTO liquidity pool on Uniswap (V2) & rewarding the liquidity providers.

What is Uniswap

Uniswap is a decentralized exchange(DEX) that allows users to directly swap ERC20 tokens without a third party. Rather than using the traditional order book model, Uniswap pools tokens into smart contracts and gives users the possibility to trade against these liquidity pools. Anyone can swap tokens, add tokens to a pool to earn fees, or list a token on Uniswap.

Why Uniswap?

If you haven’t been living under a rock you probably have heard about the terms DeFi(Decentralized Finance) and Uniswap (or any other decentralized exchange like Balancer or SushiSwap). DeFi and decentralized Exchanges have gained an insane amount of exposure and popularity in the past couple of months. YFI even dethroned Bitcoin by peaking up above the price point of $40,000 per token which was four times the price of a single Bitcoin.This also caused a new trend wave of decentralization, as many users stepped over to using a decentralized Exchange over a traditional centralized Exchange like Binance or Coinbase Pro. LTO Network is a relatively ‘old’ project within the crypto space, so we want to show the community and the industry that we’re also moving forward and keeping up with what’s going on in the outside world.

How does Uniswap Liquidity Pool work?

One of the unique features of Uniswap is that it doesn’t use an order book to establish the price of an asset like a centralized exchange does. Centralized exchanges such as Binance and Coinbase Pro determine the price of a listed asset as the meeting point between the highest price someone is willing to pay and the lowest price someone is willing to sell for. We can see in the image below that the highest bid price for BTC on Binance at one specific point was $10659.99 and the lowest asking price at that point was $10660.00. Once these prices increase respectively decrease, a match occurs and a trade takes place.

Instead of this mechanism, Uniswap uses their own exchange contracts to pool both Ethereum and a specific ERC20 token. When trading Ethereum for a token, Ethereum is sent to the contract’s pool and the token is given back to the user. As a result, the user doesn’t need to wait for a counterparty to exchange with or worry about specifying a sell or purchase price.

The amount that is returned from swapping is based on an automated market maker formula. The graph below helps illustrate how the formula works. Essentially, the amount that is returned to you is based on the ratio of Ethereum to tokens in the pool. No matter the size of a swap, the user is guaranteed to have their trade executed because the more of an asset that you add to one side of the pool, the further along the curve it pushes you for the other asset. This means the larger the order relative to the pool, the worse the rate you receive as the ratio moves along the curve.

But if users are only just sending cryptocurrency, how does the ratio of Ethereum to token remain priced correctly relative to external markets? The answer is that the pools maintain a ratio relative to the price of the rest of the market through people arbitraging the pool. Imagine that the ETH:LTO pool is expressed in terms of a scale and when the scale is balanced the pool is appropriately priced relative to the market price of a centralized exchange. Let’s say that the current price for ETH in USD on a centralized exchange is $350 and the current price for LTO in USD is $0.10. The ratio in the Uniswap ETH:LTO pool returns 3500 LTO for 1 ETH. As a result, our scale is balanced because the pool matches the current market price on the centralized exchange.

Now let’s assume that there is a movement in the market that pulls the price of ETH to $300 and the price of LTO remains the same on the centralized exchange. Due to the price movement, we can now see that our scale is off balance relative to the market price because people can now swap 1 ETH for 3500 LTO on Uniswap when the market price on a centralized exchange is $300 for 1 ETH.

In response, someone can now put ETH into the pool, draw out LTO, then sell the LTO back for ETH on the centralized exchange for profit, and then repeat. They can do this until the pool has balanced out and reflects the current market price on a different exchange.

As a result, third party arbitrages play a large role in maintaining the correct ratio of token to Ethereum in Uniswap pools.

Liquidity providers and Liquidity token

When an Exchange contract is first created for a token, both the token and Ethereum pools are empty. The first person that deposits into the contract is the one that determines the ratio between the token and Ethereum. If they deposit a ratio that is different from what the current market rate is, then an arbitrage opportunity is available. When liquidity providers are adding to an established pool, they should add a proportional amount of token and Ether to the pool. If they don’t, the liquidity they added is at risk of being arbitraged as well.

In addition, larger liquidity pools are beneficial to users because they allow for larger swaps to happen without skewing the token to ETH ratio too far along the curve. Uniswap incentivizes users to add liquidity to pools by rewarding providers with fees that are collected by the protocol. A 0.3% fee is taken for swapping between Ether and a token and roughly 0.6% is token for token to token swaps.

Lastly, special ERC20 tokens known as liquidity tokens are minted to the provider’s address in proportion to how much liquidity they contributed to the pool. The tokens are burned when the user wants to receive the liquidity they contributed plus the fees that we accumulated while their liquidity was locked.

Current Proposal

The current proposal is divided in three different phases and will roll out chronologically.

Phase 1: LTO Network will run a community vote for 5 days from 18th of September until 22nd of September, letting the community decide whether we pursue and execute the proposal or not and also deciding what the amounts are going to be of the liquidity provided by LTO and the reward for other liquidity providers.

Phase 2: If the proposal wins a majority of the community vote then LTO Network will start off by adding liquidity into the ETH/LTO liquidity pool on Uniswap. The ETH/LTO liquidity pool will consist of 50% LTO and 50% ETH, which can be accessed on Uniswap. LTO Network will incentivise liquidity providers with X amount LTO of rewards per week (Determined by the voting results). This will happen through our very own staking portal for ETH-LTO liquidity token.

Phase 3: Once users provide ETH/LTO liquidity on Uniswap, users will need to stake their ETH-LTO liquidity tokens through our own staking portal into the liquidity provider rewards staking contract. Rewards will be sent out manually at the end of each week on friday.

Community Voting Portal

Sources and inspiration:

Christian Zhang

CMO of LTO Network