Asset exchanges have historically relied on the traditional order-book-style matching of submitted bids and asks to execute trades. In 2017, Bancor exchange removed order books entirely — and instead introduced a network of on-chain liquidity pools to pair pools of tokens with one another. Users can trade against these pooled token pairs, with prices set algorithmically based on both the size of the user’s trade and the depth of the corresponding token pools.
This novel approach to market making proved to be a paradigm shift within the decentralized exchange (DEX) space. Traders now have guaranteed access to on-chain liquidity with transparent, upfront pricing, doing away with the need for a counterparty. Token owners can also turn existing holdings into productive assets through liquidity provision to these DEX pools, earning returns from protocol swap fees imposed on trades that get routed through the platform.
This has turned pooled market-maker liquidity into a new asset class (“liquidity positions”), allowing for broader, more competitive involvement in market making.
However, first-generation automated market makers (AMMs) tend to suffer from two core issues faced by liquidity providers (LPs):
Involuntary Token Exposure: LPs must be exposed to the price movements of multiple tokens in a pool, thereby losing their long positions on their favorite tokens.
Impermanent Loss: LPs are subject to value loss when the prices of pool assets diverge, causing them to under-perform a basic buy-and-hold strategy.
AMMs are revolutionary because they allow liquidity to flow from everyday users. Yet risks like involuntary token exposure and impermanent loss threaten access to AMMs for retail token holders. If users are expected to constantly monitor and act on changes in the AMM to avoid losses, liquidity provision becomes a game reserved for professional market makers.
Bancor addresses these issues with a variety of features - read about Bancor 3 here.