DeFi market making protocols enable people to exchange assets, just like the way you can go to a brokerage (Vanguard, Fidelity, Schwab, Robinhood, etc.) to buy or sell a stock, bond, or commodity.
Let’s break down how this works in traditional finance (TradFi):
In traditional finance (TradFi), I go to a brokerage to buy or sell a stock. If I want to buy a stock, the brokerage must either own it to sell it to me or find someone willing to sell theirs. If I want to sell a stock, the brokerage must be willing to buy it from me or find someone willing to buy mine. By connecting me with buyers or sellers to complete my transaction, they are acting as market makers, and earn fees for handling these transactions.
Let’s look at a simple example.
Let’s say Adam wants to buy a stock, and Betty wants to sell the same stock. They’ll both go to the broker who will “make the market” for them. The broker will offer Betty $100 to buy her stock and then will sell it to Adam at $100.05. The broker, or market maker, pockets $0.05 on the transaction.
Now, let’s take a look at DeFi.
DeFi introduces a different approach. Just like in lending, DeFi removes the middleman and uses liquidity pools to facilitate trades. People can buy and sell assets on the protocol, just like they can at a TradFi brokerage. But, instead of big institutions doing the market making in TradFi, in DeFi anyone can deposit assets with the protocol and play the role of the market maker or liquidity provider. A portion of each trade is paid as a fee to liquidity providers, rewarding them for supplying liquidity.
Let’s take a look at a simplified example.
Suppose you deposit 1,000 USDC and 1 ETH (assuming 1 ETH = 1,000 USDC) into a market making pool with total deposits of 100,000 USDC and 10 ETH. Assume each trade in this pool incurs a 0.3% swap fee and the annual trading volume is $10,000,000. You earn a percentage of the transaction fees based on your share of the pool.
The fees earned would be calculated as:
Fees = (volume x fee rate) x your share of the pool = (10,000,000 * 0.003) * (2,000 / 200,000) = 300
Yield = fees / initial investment = 300 / 2,000 = 15%
You’re halfway through the DeFi jobs! Next up, DeFi staking.