Providing liquidity can be very lucrative, but it is essential to understand the risks and the concept of impermanent loss. Decentralized finance (DeFi) is gaining a lot of attention in smart contract platforms, especially Ethereum.
DeFi allows you to create various products and operations similar to well-known financial products. Such as lending assets to other people in exchange for interest rates, as a way to monetize your tokens.
DeFI and its relationship with cryptocurrencies like Ethereum
The highly programmable Ethereum network is leading this process. Being the birthplace of many DeFis, the growth of tokenized BTC. It is a way of using bitcoin in the smart contract protocols of the Ethereum network, and the monetization of these funds in bitcoin shows this.
A particular type of DeFi has attracted the attention of the growing number of users, protocols to form automated markets such as Uniswap, SushiSwap and PancakeSwap. An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol. It relies on a mathematical formula to set the price of assets.
These liquidity protocols allow anyone to become a market maker and earn trading fees. I like to draw analogies with the traditional market. In fact, it is more familiar to our daily lives to explain new technologies. On a traditional exchange, such as B3, trades are made directly between participants.
How does it work exactly?
If you buy a stock on the stock exchange, it represents an exchange between two assets, money for shares. The trade is done by two people, one making the payment and the other receiving the money. The transaction is intermediated by the exchange system and the brokers. The latter receive trading fees for this service.
On the stock exchange or on a traditional centralized exchange with a bid book, supply and demand determine the price. On DEXs, assets are valued according to a mathematical algorithm. In addition, there is no need for another participant to carry out the operations.
In DEXs, there is no offer register, users interact with a smart contract. The latter creates the requested market and negotiations take place between users and contracts.
DEXs can be very advantageous for those who want to buy or sell expressive quantities of a certain asset. Both on the stock exchange and in traditional exchanges. Low-liquidity assets have a considerable price variation, precisely due to the absence of a counterparty.
Who are the liquidity providers?
But for all this to work, the liquidity of smart contracts must be ensured by users, called liquidity providers. Liquidity providers add funds to the "liquidity pools". This is done in exchange for contributing money to the protocol. In fact, they receive commissions on the transactions they make.
In most protocols, it works like this. In addition, the sum of the transaction fees of the previous day is automatically distributed to liquidity providers based on their participation in the pool.
Uniswap, for example, charges users a fee of 0.3%. It goes directly to the liquidity providers. Providing liquidity to a pool can be a very profitable business. But one must understand the risks and especially the concept of impermanent loss.
What is impermanent loss?
Impermanent loss occurs when the price ratio of the deposited tokens changes after you deposit them into the pool. The higher the volatility, the greater the impermanent loss.
In most pools, the ratio between assets is 50%, i.e. half the liquidity for each asset. Let’s say you deposit tokens into a liquidity pool that have a value equivalent to $100. In this example, $50 will be allocated to asset A and $50 to asset B.
If one of the assets starts to depreciate too much, you will have to rebalance, because the algorithms ensure that the liquidity ratio between the pairs remains the same, and this process can shatter your capital.
Another implication of this is that liquidity providers do not benefit from extraordinary valuations either.
Impermanent loss is not a good name for this phenomenon, because the term "impermanence" may give the impression that the assets will at some point return to the prices at which they were originally deposited, but this may not happen, plus if you withdraw your funds at a different price ratio than the one at which you deposited them, the losses will be permanent.
