Author Rui, blockchain gal, web3 founder.
Twitter: @popolandRuii
TL;DR
- The invention of AMM is the sign of the start of Decentralized Finance
- Liquidity Providers(LP) are who deposit their cryptocurrency assets into a liquidity pool, they can earn trading fee, LP reward, arbitrage profit and governance token as reward.
- Liquidity mining is a mode that incentive LP to participant in an early pool that need liquidity using their native token.
- The risk of impermanent loss will be faced by LP when they deposit risk assets. The total returns equal to Trading fees(yield) minus impermanent loss.
- To become a LP, you can choose LP for stablecoins, similar assets, cross-chain bridge, risk assets, etc. Bigger risks win you higher reward.
To measure the health of a market, we often use trading volume, volatility and liquidity.
Liquidity is the measure of how easily you can convert an asset into cash or another asset. Desirable markets have high liquidity and small bid-ask spread that traders are able to enter and exit position with relative ease.
The blossom of Decentralized Exchange(DEX)
The blossom of Decentralized Exchange(DEX) means there’re no threshold for trader participant in crypto market, and could abandon the government’s restriction, allows higher efficiency on marketing competition.
The traditional market and centralized exchange use order book mode, which is a list of buy and sell orders for a particular asset, and market makers play an important role to support the market by placing both buy and sell orders in the order book, which creates liquidity and helps to stabilize the market.
While DEX couldn’t adopt the traditional market maker mode, since it’s totally decentralized and has no central order book; Peer-to-peer basis that the cost of providing liquidity is distributed among the users not the professional market maker and it may cost high when market makers cancelled orders on the frequently-changing market.
The invention of Automated Market Maker(AMM) is the sign of the start of Decentralized Finance. AMMs use a mathematical algorithm to determine the price of assets based on the supply and demand of the assets within a liquidity pool. Liquidity providers deposit a pair of tokens into a liquidity pool, and the AMM algorithm sets the price of the tokens based on their relative proportions in the pool.
When a trader wants to execute a trade, they interact with the AMM and trade against the liquidity pool, which automatically adjusts the price based on the trade size and token balances in the pool. This process ensures that the price of the assets remains stable and responsive to changes in supply and demand.
What is Liquidity Provider(LP)?
A liquidity provider (LP) is a user who provides liquidity to a decentralized exchange (DEX) by depositing their cryptocurrency assets into a liquidity pool. Liquidity pools are a core feature of DEXs that use Automated Market Maker (AMM) protocols to enable decentralized trading.
When an LP deposits their assets into a liquidity pool, they receive liquidity pool tokens in return, which represent their share of the pool. These tokens can then be used to withdraw the LP’s portion of the assets from the pool at any time.
Separate sources of income for liquidity providers
- Trading fee:
When a trade is executed on a DEX, a small percentage of the total trade is charged as a trading fee, which will be spit between the LP and the platform’s governance token holders. In another word, LPs earn a portion of the trading fees as incentive. - LP reward:
Many DEXs also offer additional LP rewards in the form of tokens. These rewards are typically provided as an incentive for LPs to contribute liquidity to newly-launched pools or to specific pools that are experiencing low liquidity. The amount and type of LP rewards offered can vary widely between different DEXs and can change over time. - Arbitrage profits:
If there is a price discrepancy between the same token on different exchanges or between different trading pairs, arbitrageurs can earn a profit by buying low on one exchange and selling high on another. If LPs on a DEX are providing liquidity for a trading pair with a price discrepancy, they can potentially earn a portion of the arbitrage profits. - Governance tokens:
Some DEXs and DeFi protocols offer governance tokens to their LPs, which can allow LPs to participate in platform governance and decision-making. If the value of these governance tokens appreciates, LPs can potentially realize a profit by selling them.
What is Liquidity Mining and the limitation?
The origin of liquidity mining can be traced back to the need for sufficient liquidity on DEX- Uniswap in November 2018, and its adoption has been driven by the desire to incentivize users and drive growth in these new financial ecosystems.
Liquidity mining incentivizes users to provide liquidity to a DEX by offering rewards in the form of cryptocurrency tokens. These LP rewards are intended to compensate LPs for the opportunity cost of providing liquidity to the pool, as well as to encourage more users to provide liquidity to the pool, thereby improving the depth of the liquidity pool.
However, there’re limitation of liquidity mining mode:
- Vast majority is not loyal, they will abandon the current DEX for a higher LP token.
- Liquidity mining offers huge pressure on native token, unfortunately the token price is very often associated with the overall quality of the project.
- Some protocol tried to mitigate this problem by adding vesting to liquidity mining rewards,same issue need to be confronted in the future
Right now Uniswap stopped providing LP token since the strong brand and trading volume allow LP earn a relative high return just by the trading fee. The first-mover advantage becomes more and more obvious as time goes by.
The goal of all DEX is build the MOAT: After the liquidity mining is over, the protocol can remain appealing to the users by establishing a reputable brand, attracting long-lasting liquidity.
What is impermanent loss?
Impermanent loss happens when you provide liquidity to a pool, the price of your assets changes compared to when you deposited them.
Stablecoins and all the wrapped coin often stay in a relatively contained price range and smaller risk of impermanent loss, on the contrary, risk coins face big risk impermanent loss but higher reward as well.
The impermanent loss happens no matter which direction the price changes, up or down. Only the price ratio relative to the time of deposit matters.
How many ways can we be a liquidity provider(LP)?
- LP stablecoins:
Provide two stablecoins, such as BUSD and USDT in a pool. You won’t face the impermanent loss but also get a relative low yield around 3%. - LP similar assets:
Provide crypto assets are similar in price, such as ETH and stETH also reduce impermanent loss, yield around 3%. - LP stablecoins/ similar assets + incentive:
Every blockchain has their own liquidity market that provide extra incentives in their own token besides liquidity reward:
eg. Avalanche — traderjoe, BSC — pancake, Polygon — quick swap, ETH — curve, etc. - LP bridges:
Provide cryptos on the cross-chain bridge, the pro is you will earn the LP fee and also farming rewards which is around 10%-14%, the con is the cross-chain bridges are not secure enough these days and could be easily target by hackers. Risk earns you more.
5. LP risk assets:
Provide risk assets onto liquidity pool, such as BNB and USDT on Pancake Swap, you will earn the yield and also face the risk of impermanent loss. Usually high LP rewards will be provided by the smaller coins that price change more frequently.
The total returns=Trading fees(yield) — impermanent loss. To decide LP or not, you need to pridict how much the asset will move in price when you put them in and take them out, and compared to how much yield you get, the result is negative or positive.
References:
https://academy.binance.com/en/articles/liquidity-explained
