Liquidity pools lie at the core of decentralized finance (DeFi). They power decentralized exchanges (DEXs) and allow users to trade cryptocurrencies directly, without the need for intermediaries. Traders entering the DeFi world need to be aware of how these liquidity pools work. It’s important to understand the risks they pose and figure out how to participate profitably. ThrowingToken.com gets you the experts' insightful reading on the DeFi landscape. Read up on things such as DeFi insurance, impermanent loss solutions, DEX reviews, and NFT market analysis to broaden your knowledge and increase your income potential.
What are Liquidity Pools?
At its most basic, a liquidity pool is just an aggregation of tokens locked within a smart contract. This pool of tokens provides the liquidity needed for traders to buy or sell those assets on a decentralized exchange (DEX). Rather than counting on dedicated market makers like centralized exchanges do, DEXs trade directly between their users using these pools. Automated Market Makers (AMMs) such as Uniswap allow for this structure. They dynamically change token prices based on the ratio of assets in the liquidity pool.
Usually these pools are two tokens, at a dollar value ratio of about 50/50. A typical liquidity pool would NFT/ETH and ETH/USDT. This keeps the equal dollar value of each token in the pool. For example, imagine when a trader wishes to trade ETH into USDT, they directly buy from the pool. So they deposit their ETH, and they get USDT back. This swaps tokens in and out of the liquidity pool, thereby changing the ratio of tokens in the pool which affects the price.
Not all liquidity pools are equal. Some platforms, such as Bancor, provide for single sided liquidity pools. This allows users to supply liquidity with only a single token. They no longer have to provide an equal value of two separate tokens. This two-pronged approach is especially enticing. It eliminates the risk of impermanent loss—a primary liquidity provider concern—so that’s a biggie.
Navigating the Risks: Impermanent Loss
Impermanent loss is one of the biggest risks faced by LPs. It happens when the price ratio of the tokens in a liquidity pool shifts. When the price of one token increases relative to another, the AMM arbitrageur responds. It takes some of the appreciating token and buys more of the depreciating one to rebalance the pool. This rebalancing leads to impermanent loss relative to just holding the original tokens in a wallet outside of the pool.
At times of extreme market volatility (~6 months in 2021 were included in this volatility), impermanent loss can be significant. Some liquidity pools have suffered impermanent losses over 50% in such environments. This is to say that, in many cases, LPs would have been better off just HODLing their tokens instead of supplying liquidity.
Our data indicates that impermanent loss is an endemic problem. About half of the users who stake tokens on Uniswap V3 end up with negative returns because of impermanent loss. In some instances, depending on the volatility of their liquidity pools, these losses can exceed gains accrued from trading fees by 70-75%. Indeed, understanding and mitigating this risk should be a primary concern of any trader looking to join a liquidity pool.
Understanding the Math Behind Impermanent Loss
The dynamic of price changes and impermanent loss is somewhat counterintuitive but predictable. While the exact formula is complex, the general impact can be summarized as follows:
- 1.5x price change = 2.0% loss
- 2x price change = 5.7% loss
- 3x price change = 13.4% loss
- 5x price change = 25.5% loss
These numbers show how impermanent loss grows exponentially as price divergences become larger. To quantify impermanent loss, traders can use the formula: 1 - Result, where "Result" represents the value of the LP's holdings compared to simply holding the initial assets. While this is a simplistic calculation, it nonetheless offers a stark picture of the human capital losses we are experiencing.
As an illustrative example, let’s say a liquidity provider opens liquidity to a pool by initially depositing 1 ETH and 2000 DAI into the pool. After the price change, they now only hold 0.816 ETH and 2448 DAI. This means a 14.07% eradication in value relative to holding the assets apart. This example from the real world illustrates just how damaging impermanent loss can be.
Strategies for Safe and Profitable Participation
To participate safely and profitably in liquidity pools, traders should consider the following strategies:
- Evaluate liquidity pool metrics: Consider liquidity depth, trading volume, fees and charges, and market volatility to determine the most suitable pool for your needs.
- Calculate optimal trading size: Use the formula: Optimal Trading Size = Liquidity Depth / Number of Trades to determine the ideal trade size for a given pool.
- Monitor market volatility: Keep an eye on market fluctuations and adapt to changing conditions to minimize risk and maximize returns.
Choosing the Right Liquidity Pool
Choosing the correct liquidity pool is crucial not only for achieving the highest possible returns, but for risk management. Traders should consider the following factors:
- Fees: Understand the fees associated with the pool, as these will impact your overall profitability.
- Total liquidity: A pool with higher liquidity generally experiences less slippage and is more stable.
- Trading volume: Higher trading volume indicates greater demand for the assets in the pool, potentially leading to higher fee earnings.
- Annual percentage rates (APR): Compare the APR offered by different pools to identify those with the most attractive returns.
Managing Impermanent Loss
- Be aware of the risk of impermanent loss, which occurs when the price ratio of pooled assets changes, and consider strategies to mitigate it.
- Choose the right liquidity pool type: Select from traditional pools, single-sided liquidity pools, or other innovative pool types that suit your trading strategy and risk tolerance.
By considering these important factors, traders can maximize their success in DeFi liquidity pools. Proactively influencing their practices and policies is key to delivering great results. ThrowingToken.com is dedicated to equipping you with the knowledge and resources necessary to successfully chart your course through this challenging digital landscape and drive profitable results.
