Liquidity providing is definitely a new finance concept that did not exist before Defi. As many people have transformed to be degen farmers, many others, including investment funds, prefer to stay away from it for fear of the infamous impermanent loss. There is a good deal of research and analysis about this topic online. Different to the technical analysis, I will narrate liquidity providing as an alternative among the common investing strategies and give alternative perspectives to measure the gain and loss.
This article will give you open thoughts on:
- Do I earn or lose money when providing liquidity?
- Is impermanent loss really a loss?
- How to choose a pool to provide liquidity?
If you are thinking about one of these, continue to read.
First thing first. What is liquidity providing?
Providing liquidity is depositing one’s own crypto tokens into an AMM(Automated Market Marker) liquidity pool. Swapping of tokens happens inside the pool. An AMM pool uses smart contracts to manage the transactions automatically. In this article, I will only talk about the most classic pool of two tokens (let’s say token A and B) and use the Constant Product Market Maker algorithm:
x * y = k
where x is the quantity of token A and y is the quantity of token B. Besides, token A and B should have the same value, value = token quantity*token price. When trades happen, the smart contract automatically balances the quantities of tokens in the pool. A token’s price is determined by its quantity ratio versus the other token. I had this article that explains the whole thing more in detail.
The liquidity provider (LP) provides liquidity and gets an LP token representing his share in the pool. The pools give LPs the trading fee for rewarding them. The trading fee is expressed as a percentage of the trading volume, usually 0.3% — 1%. An LP receives the fee proportional to his share in the pool. The collected fee is re-invested in the pool; thus, k increases with trades. Consequently, the LP token will contain more tokens A and B over time.
Many protocols further incentivize LP by giving out yield farming rewards on top…