Liquidity Pools Explained
In the world of decentralized finance (DeFi), one of the most important aspects of a healthy ecosystem is liquidity.
Without liquidity, there can be no market activity, and without market activity, there can be no price discovery or price availability. One of the ways to obtain liquidity in the DeFi space is to use a liquidity pool.
Liquidity pools are a DeFi market making investment tool that do not rely on traditional capital-rich market makers. While order books are efficient for traditional markets, crypto markets charge fees which makes it difficult for the market makers to profitably provide liquidity. If you become a liquidity provider by depositing your tokens into a liquidity pool, you can then trade like a market maker and get rewards for the collected fees from all the trading activity.
Let's have a look at how liquidity pools work on WX.Network.
In September 2022, the APY (annual percentage yield) for supplying liquidity to the USDC/USDT trading pair on WX.Network was up to 43%. The demand for liquidity pools comes from market participants needing a pool of available liquidity to swap USDC for USDT or vice versa. Users who hold both USDC and USDT can contribute to creating a market by depositing their tokens into a liquidity pool and earning up to 43% APY in return.
Upon depositing their USDC and USDT tokens into the liquidity pool, users receive a ‘USDCUSDTLP’ LP token representing their share of the tokens in the pool. When users exit a pool, their LP token gets burned in exchange for the tokens they initially deposited plus the rewards accrued from providing liquidity. The larger the pool, the more fees it will generate and the more rewards will be paid out to liquidity providers.
Liquidity providers' income can come from a variety of sources such as a percentage of platform trading fees, and staking rewards proportional to the length of time they are willing to leave their stake as liquidity in the protocol.
What Are Yield Farming Rewards?
The rewards generated from liquidity pools may come from two sources:
- Bonus yield that the protocol offers to incentivize users to provide liquidity
- Fees generated from market participants conducting swaps
Yield farming is the strategic ‘harvesting’ of these rewards that creates a win-win scenario for the users and DeFi protocols. Liquidity providers receive yield in the form of a governance token or a yield token and protocols receive decentralized bootstrapped liquidity. The larger the share of liquidity a provider has contributed to an LP, the larger the yield they can harvest from their LP. Yield farming has become a popular passive income strategy for those who know how to take advantage of LP rewards.
With the current surge in popularity of yield farming, it is important to do your own research and understand the fundamentals before taking part. Here are some factors you should consider:
- Incentives: What are the motivations behind this project? What is being offered to LPs? How long will these incentives last? Is the project sustainable without them?
- Protocol fees: Are there any protocol fees? How much are they? Where does this revenue go?
- Tokenomics: What is the token distribution like? How is inflation handled by the protocol? Is there a buyback/burn mechanism in place?
- Governance: Who makes decisions about the protocol? How decentralized is it? What processes are in place for community input?
- Risk: What are the risks associated with this project? Is it over-collateralized? What happens if there is a flash crash?
Before yield farming on any platform, be sure to understand the basics of how the protocol works and the risks involved. With a little research, you can find yield farming opportunities that fit your risk profile and help you earn some extra income.
When a new liquidity pool is formed, typically this yield comes from protocol incentivization. Upon launch, the protocol usually keeps a small percentage of the token supply aside as incentives. The earliest LPs are paid out in these native tokens as a reward for bootstrapping liquidity for the protocol.
After the liquidity pool gains some traction then the rewards switch from incentivization to service provision. There is typically a fee set for each pool which is taken as protocol fees. The fees generated from trading activity in these pools is proportionally redistributed to LPs in that pool and becomes the source of yield going forward.
LPs who provide liquidity early, own a larger proportion of the pool and can collect more rewards. As the number of LPs and amount of liquidity in a pool grows over time, the yield each LP earns decreases. Eventually, yield farmers may exit their position and reallocate their funds into the next pool.
What Are the Risks of Providing Liquidity
While liquidity pools can be a great way to generate passive income, it’s important to understand the risks involved in providing liquidity. Perhaps the biggest risk is the impermanent loss (IL) associated with providing liquidity. IL occurs when the price of the tokens in a pool changes and one token becomes more valuable than the other. This results in LPs selling their less valuable token to buy the more expensive one, incurring a loss.
Long story short, impermanent loss illustrates the difference between how much more the liquidity providers would have had if they simply held their tokens instead of providing liquidity in a pool.
This occurs when the price of an invested token in a liquidity pool changes in relation to another in any direction. The larger the change is, the larger is the impermanent loss. Impermanent losses are called impermanent or unrealized because they are not recorded until the tokens are withdrawn from a liquidity pool.
The loss becomes permanent only if a liquidity provider decides to withdraw liquidity from a pool. In other words, if you decide to withdraw liquidity, at some point where one of the tokens has fallen in value, its value may be less than when you provided it, and the loss becomes permanent.
How Impermanent Loss Works
Say you deposit 100 USDC and 5 WAVES in the WAVES/USDC pool ($200 in total, at the price of 1 WAVES = 20 USDC).
If the market price of WAVES drops to 15 USDC, then the AMM (Automated Market Maker) algorithm will automatically balance the ratio of tokens in the pool and change their value according to the following formulas:
USDC amount × WAVES amount = constant
Calculating, we get that the value of your tokens in the pool is $173.2 (86.6 USDC and 5.77 WAVES).
If you instead held the tokens in your wallet, then the value of the tokens would be $175 (100 USDC and 5 WAVES). In this example, the impermanent loss is $175 - $173.2 = $1.8.
Impermanent loss is an inherent risk of providing liquidity to pools, and it directly depends on the volatility of a trading pair. To minimize potential losses, users can invest in stable pools such as USDT/USDC.
So, if the impermanent loss can take away profit, what do liquidity providers choose to provide liquidity in the first place?
To find the answer, keep in mind the following ideas:
- The price of LP tokens slowly grows over time in any case. So, the holders can still make profit even in the case of impermanent loss, assuming that the impermanent loss is less than the LP token price growth based on trading activities.
- Staking LP tokens provides rewards in WX token.
- Staking WX token provides additional rewards in WX token and simultaneously increases the LP tokens staking rewards in all the pools.
All these sources of earnings can make investing in liquidity pools profitable and in many cases, offsets the potential downside risk of impermanent loss.
WX.Network Liquidity Pools
Currently, Waves has a number of different pools available for users to provide liquidity and earn rewards on the WX Network decentralized exchange (DEX). The EGG/USDC pool dor example, may offer much higher yield than other pools, but the token pair’s high volatility means increased risk of impermanent loss for inexperienced users to manage.
WX.Network also provides pools with lower yields – and risk – that offer a more consistent rate of return without the hassle of active management. The USDC/USDT and USDT/USDC pools have the least risk as stablecoins fluctuate in price very little and pose very little impermanent loss risk.
Stablecoin pools do expose holders to risk of a depegging event. Stablecoins are vulnerable to depegging, depending on how they are designed. A depeg happens when the price of the stablecoin drops below the price of the asset it’s pegged to for a prolonged period of time.
The Next Frontier of Finance
Providing liquidity with different tokens, in different combinations comes with a spectrum risk-reward trade-offs. As with any cutting edge technology, the new frontier of financial technology is an entirely new way to invest and should be done with caution and awareness
A common way of experimenting with Waves.Exchange liquidity pools, is to diversify risk exposure by distributing a portfolio of positions in liquidity pools with high yields and APY’s and lower yields and APYs. Portfolio diversification minimizes the downside, while retaining the potential of greatly outperforming on the upside.
Together, protocols like Waves.Exchange and the LPs supporting its liquidity pools, share the risks and rewards that come with building out the foundations of tomorrow's unstoppable, decentralized crypto economy.
Visit WX.Network liquidity pools to find a pool that fits your risk tolerance and start earning rewards today.