LP'ing Is Not Staking or Lending
Today we're talking specifically about being a Liquidity provider (LP) to a decentralized exchange. This is not to be confused with staking, bonding, lending or locking tokens.
Automated Market Makers
To understand LP'ing, first you ned to understand what an Automated Market Maker (AMM) is. Often referred to as a decentralized exchange or DEX, an AMM is very different from a centralized exchange like Coinbase or Kraken.
Typically when you hear the term "swap" we're referring to an AMM. Some examples include:
- Ethereum - Uniswap, Sushiswap, Curve
- Binance Smart Chain - Pancakeswap
- Thorchain - Thorswap
- Fantom - Spookyswap, Spiritswap, Solidly, Beets, Excalibur
- Aggregators - 1inch, Matcha, Paraswap, ShapeShift
These AMM's are made up of pools of liquidity, typically two tokens paired together at a 50/50 ratio. For example, the ETH-USDC pool on Uniswap currently contains $392M total, $196M worth of USDC and $196M worth of ETH.
There's lots of sophisticated math that goes into how AMM's work under the hood, but the important thing to remember is that as traders swap one token for another, the always AMM rebalances itself back to 50/50.
Fees & Rewards
Just like Coinbase charges you a fee to trade, decentralized exchanges charge a fee to swap your coins! Uniswap famously charges 0.3% per swap, but instead of Uniswap making all that money, fees are paid to people who provide the liquidity, that could be you!
But fees aren't the only source of income. For example, Curve’s stETH pool currently pays 1.99% base fee (thats from fees), $CRV rewards add 0.32-0.8%, LidoFinance is incentivizing 1.41% of $LDO and if you harvest with Convex you can squeeze out an extra 0.91% in $CVX as well.
The APY earned from each pool can fluctuate dramatically from moment to moment. Yield earned is dependent on:
- Pool Depth - The Total Value Locked (TVL) in the pool. The more TVL, the less rewards and fees you'll earn since they're shared across all LP's.
- Pool Trading Volume - If the tokens in the pool are swapped between each other often, they'll generate more fees hence a higher rate of return.
- Reward Token Prices - Typically the rewards issued are a predetermined quantity per day, week or month. If the token price goes down, so does your ROI.
There are two primary risks to look out for when being an LP:
- Price Exposure - When entering an LP position, you're exposed to price fluctuations of all assets in that pool, even if you enter the pool asymmetrically (with one token instead of both).
- Impermanent Loss (IL) As the price of the assets in the pool diverge from each other, arbitrageurs are incentivized to bring the pool back in balance. Their reward is your loss.
Many people confuse and combine these two risks simply calling it IL, but they're very different! We'll see some examples of price exposure below, but for Impermanent Loss you can use an IL calculator.
Types Of Liquidity Pools
At the end of the day, there's only three types of liquidity pools that exist:
- Stable-Stable - Both assets are stable coins (USDC/UST) or the price of both assets are pegged to each other (ETH/stETH).
- Stable-Volatile - One asset is a stable coin and one is volatile (USDC/ETH).
- VolatileVolatile - Both assets are volatile (BTC/RUNE).
Stable coin and pegged asset pools are my favorite and easiest to understand. Since the prices of all assets pin the pool are designed to stay the same, there's no LP risk! (obviously there's still smart contract and hack risks...). This is the only scenario where you'll likely withdraw the same quantity of tokens as you put in, plus rewards.
The example below shows a Stable-Volatile LP position where the price of $RUNE goes up 50%. As you can see, this results in less $RUNE than you initially deposited! In most cases, if you're bullish on a token, you'd be better off simply hodling it in your wallet than pairing it with a stable coin! That is, unless the rewards paid you more during that time than the cost of losing out on 50% of the upside...
Volatile-Volatile pools can be tricky to calculate and you'll almost certainly end up withdrawing a different quantity of tokens than you initially deposited. The trick, is to pair two assets which are highly correlated. If they both go up or down at the same rate (similarly to a Stable-Stable pool) you'll do ok! This example shows how you'll withdraw less $RUNE than you initially deposited when the price of the paired asset goes down.
Important to notice that even though the price of $BTC went down 40%, your overall position only lost 20%. That's because you're technically holding both assets even though you only deposited one.
How To LP
Every AMM works differently, so it's important to learn as much as you can and run some tests before diving into the deep end of the pool. But at a high level, LP'ing goes something like this:
- You select an AMM.
- You select a pool within that AMM.
- You deposit your liquidity either symmetrically (equal parts) or asymmetrically (one sided)
- Remember, if depositing only one side behind the scenes the AMM is immediately swapping half your position for the other token, exposing you to the price of both assets!
Go Even Deeper
To better understand these examples and more, read Sam's Medium article and watch this video describing each of the LP examples above in depth.
Written by: @gerbz Gerbz is the founder of BitLift and has been journeying down the crypto rabbit hole since 2013.