CeDeFi Academy: AMMs, Liquidity pools, Yield farming, Impermanent loss

The decentralized finance (DeFi) sector is replete with new opportunities. From automated market makers (AMMs), which allow users to trade digital assets in a permissionless way, to liquidity pools, where users can “farm” yield and enjoy high APYs, there are numerous ways to benefit from DeFi.

However, before dabbling in this promising industry, Algoo Strategies recommends understanding some of its main components, how they work, and the risks associated with them.

What Are AMMs?

Automated market makers (AMMs) are decentralized trading pools that allow market participants to buy or sell cryptocurrencies in a permissionless and automatic way. AMMs have evolved to become one of the most popular DeFi applications as they power all decentralized exchanges (DEXs).

To better understand AMMs, it is important to know what market makers are. In traditional finance, market makers are liquidity providers that quote both a buy and a selling price on a tradable asset in the hope of making a profit on the bid-ask spread, or turn.

Banks and brokerage firms are the main market makers in TradFi. These are generally brick-and-mortar organizations that facilitate the process required to provide liquidity for trading pairs on centralized exchanges. Some of the biggest market makers are names familiar to everyone, including Morgan Stanley, Credit Suisse, Deutsche Bank, and more.

Since traditional market makers are controlled by centralized entities, they have full control over their operations. This also gives them the power to manipulate markets to their own benefit. For instance, a market maker may buy shares of a company for their own accounts and then flip them hours later for a profit.

To tackle this issue, DeFi has given birth to AMMs. Leveraging blockchain technology and the power of smart contracts, a set of programs stored on a blockchain that run when predetermined conditions are met, AMMs automate the process of providing liquidity for trading pairs, removing the need for centralized entities and also making trades more efficient and transparent.

AMMs are a crucial part of DeFi as they power all DEXes. Instead of using an order book like centralized exchanges (CEXes), DEXes use AMMs, which in turn utilize smart contracts to define the price of cryptocurrencies and provide liquidity.

Technically, DEX users do not trade against counterparties, rather they are trading against the liquidity locked inside smart contracts. These smart contracts are often called liquidity pools. Examples of AMMs include Uniswap, Balancer, and Curve.

What Are Liquidity Pools?

Liquidity pools are piles of digital assets locked in a smart contract that provide essential liquidity to DEXes. As noted above, liquidity pools are an essential part of AMMs, and one of the foundational technologies behind the current DeFi ecosystem.

To better understand liquidity pools, it is important to know liquidity first. In simple terms, liquidity is when assets are converted to cash quickly and efficiently, avoiding sharp price swings. Therefore, it is easy to see that liquidity is an essential part of both the crypto and financial markets.

If an asset is illiquid, either in TradFi or DeFi, it takes some time to convert it to cash or other liquid assets. During this period, users could also face slippage, which is the difference between the expected price of a trade and the price at which the trade is executed, and thus end up with less cash than first anticipated.

In TradFi, banks, financial institutions, principal trading firms (PTFs), and other organizations provide liquidity. However, since DeFi aims to undercut centralized entities, it uses liquidity pools to gather liquidity.

Unlike TradFi, where high-net-worth clients can only provide liquidity, all DeFi users can become liquidity providers as long as they meet the requirements hardcoded into the smart contracts of different AMMs. Users who provide liquidity are called liquidity providers (LPs)

In order to incentivize LPs, liquidity pools in DeFi offer rewards in exchange for the amount of liquidity they supply. This reward is usually a fraction of the fees a DEX or an AMM generates and is distributed in the form of the protocol’s native token. These tokens can then be used in different ways or simply traded for cash.

What is Yield farming?

DeFi is replete with money-making opportunities that enable users to put their cryptocurrencies to work and generate income. One such strategy is yield farming, which is the process of lending or borrowing crypto on a DeFi platform in exchange for cryptocurrencies.

To incentivize LPs to stake or lock up their crypto assets, yield farming protocols offer high rewards that can be a percentage of transaction fees, interest from lenders, or their governance tokens. These returns are expressed as an annual percentage yield (APY).

The APY rate of a yield farming protocol is proportionate to the total value of staked assets. As more investors lock up their funds in a liquidity pool, the value of its issued returns decreases. On the other hand, when investors start pulling out their funds, the APY rate increases in order to attract new stakers and increase liquidity.

Initially, yield farmers were able to stake their assets and earn rewards. However, with the prominence of so-called liquidity mining, which enables yield farmers to get a new token as well as the usual return, yield farming became even more powerful and attractive.

Liquidity mining became popular after Compound started issuing its governance token COMP to its platform users. At the time, Compound gained huge traction by bolstering the returns on deposits to its lending platform with COMP token rewards. The skyrocketing value of COMP made this program even more attractive.

What is Impermanent loss?

Yield farming in DeFi offers the opportunity to earn high returns, but it also comes with some risks. Apart from the obvious risks of hacks and exploitations, there is also an impermanent loss in yield farming.

Impermanent loss refers to the fact that the USD value of the withdrawal from yield farming is lower than the dollar value of the deposit. That can happen if the value of the cryptocurrency that a user locks plunges. For instance, if a user stakes 2 ETH when the ethereum price is at $4,000 and withdraws when the price is at $2,000, they have incurred an impermanent loss.

As the name implies, this loss is impermanent because no loss happens if the cryptocurrencies recover their losses (i.e., return to the same price when they were deposited on the AMM). Furthermore, the reward liquidity providers receive can help offset the risk exposure to impermanent loss.

It is important to note that liquidity providers cannot avoid impermanent loss on volatile cryptocurrencies like ETH. However, they can avoid temporary losses by choosing stablecoin pairs that offer the best bet against impermanent loss since they are mostly stable.

AlgooStrategies.org Uses AMMs, Liquidity Pools in CeDeFi Strategies

Algoo Strategies, the first CeDeFi custodial platform that serves as a gateway between DeFi and CeFi, uses strategies that combine working with digital assets and various protocols to create profitable, intuitive investment tools. Some of these strategies make use of AMMs and liquidity pools to offer users high returns.

For instance, Algoo Strategies has recently revealed three new “CeDeFi” strategies aimed at creating new opportunities for Algoo users during the current bear market. One of these strategies, called DeFi Token Farming, is a basket of incentivized liquidity pools with DeFi tokens on popular AMMs (like Curve) that can generate up to 35% ROI.

The DeFi Token Farming strategy uses top-tier liquidity pools in all of DeFi, each of which includes incentivized rewards from Convex. Convex is a platform for CRV token holders and Curve liquidity providers to earn additional interest rewards and represents the primary source of the strategy’s yield.

Notably, the other two CeDeFi strategies use Alpha Homora and Aura Finance, a leveraged yield farming product, to create leveraged positions on a basket of ETH-Stable liquidity pools. Called “Soft Long on ETH” and “Soft Short on ETH,” the strategies aim to generate 45% ROI and 25% ROI through price movements of ETH and rewards for providing liquidity.

AlgooStrategies.org is a custodial CeDeFi platform seeking to bridge the gap between CeFi and DeFi, combining the former’s reliability with the latter’s high profitability. The platform implements a strict risk management policy and mandatory audits of all products in a bid to enhance security and transparency standards while reducing the possibility of fraud.