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Introduction
Liquidity pools represent one of the technologies underlying the DeFi ecosystem: they are smart contracts whose sole purpose is the custody of cryptographic tokens, provided by users called Liquidity Providers, and make them available to decentralised protocols that require liquidity. This concept, very simple in itself, is fundamental in Decentralised Finance, as it is functional to ensure the key element on which all the services of this industry are based, i.e., the guarantee of liquidity as an indispensable element for the proper functioning of decentralised platforms (DEX).
Liquidity Pool, AMM and Liquidity Mining … one concept, countless services
As anticipated, a liquidity pool is a set of cryptocurrencies contributed in pairs of equal amounts, typically 50% and 50%, (for example USDT / ETH, USDC / DOT) locked in a smart contract and contributed by users who they wish to obtain a passive income for this service on the tokens they own in the pool. The income derives from the sharing of the commissions paid by other users of the decentralised platform to which liquidity was provided.
There are different types of decentralised services made available to DEX platforms, whose use generates compensation for liquidity-providing users. Among the most important and widespread in the DeFi ecosystem we find crypto token trading.
The main difference between a centralised and a decentralised trading operation is that in the latter a counterparty is not involved. On the one hand, in a CEX exchange, token purchase requests are associated with token sales requests. On the other hand, the use of DeFi trading entails the execution of operations without the presence of a centralised counterparty: there are no companies such as Binance, Coinbase, Kraken or Young Platform in this context, and neither a tool called order book. In the DEXs, the entire token exchange process and the entire execution of the transaction, actually takes place through the liquidity present in the liquidity pool, contributed by the liquidity providers.
This happens because every interaction through a centralised book would be extremely expensive in terms of gas fees, and given the enormous increase in the number of transactions in recent years, the work of the market makers (which is to always guarantee continuous liquidity to pairs of tradable tokens) would be enormously difficult. Without considering the fact that many blockchain, such as Ethereum, would not be able to natively ensure the correct execution of this incredible number of transactions.
The need, dictated precisely by the explosion of services and volumes on the blockchain, to manage trading activities efficiently, has led to the development of specific algorithms defined as AMM (Automated Market Makers), capable of ensuring “automatic market making” and consequently trading without the need for a traditional order book, in a completely decentralised way.
Thanks to this total decentralisation and the permissionless features of DeFi, in which any user can become a Liquidity Provider, it is possible to exploit this enormous amount of liquidity to exchange many different types of tokens with each other: unthinkable operations on a centralised platform in which many pairs, especially the most exotic, would probably be illiquid and difficult to negotiate.
It is therefore pure decentralised finance, in which the counterparty of an operation is not represented by another user willing to accept a specific transaction, but it is the smart contract, having the liquidity present in the pool, which allows the execution of the service.
The concept of decentralised transaction just described can be extended to many other services offered by the several DEX protocols that are gradually developing on the various platforms: DeFi insurance, tranching services, synthetic asset issuance, etc.
Example of liquidity pool operation in Uniswap
Source: uniswap.org
As can be seen from the figure above, the liquidity provider deposits 10 tokens A and 1 token B in the pool, obtaining 4 LP tokens in exchange, while instead a trader, to have a token B, pays 10 tokens A and a commission of 0.03% Interestingly, the parties approach the liquidity pool and smart contracts directly, without the need for a counterparty.
The mechanism does not change: in any case there will be a smart contract that will execute the different types of transactions by appealing to the pool and consequently to the liquidity contained therein, consisting of the pairs of tokens contributed by the liquidity providers.
As we have seen, in a similar way to staking, users who keep their tokens locked in the smart contracts (liquidity pools) of the DeFi protocols are rewarded with part of the fees generated by the protocol itself in the execution of their services.
The main difference between staking and liquidity mining lies in the fact that:
- staking, through the Proof of Stake algorithm, is used to ensure the correct functioning of the blockchain itself (which is why users who block tokens are paid for this to happen).
- On the contrary, liquidity mining is to ensure, through the liquidity pool, the correct functioning of the DeFi services provided by the DEX, and for this reason the users providing liquidity are remunerated.
Ultimately, the introduction of these liquidity pools and the use of passive income strategies has started the revolution of the cryptocurrency holding, (renamed HODL in the crypto sector), since these mechanisms allow to obtain dynamics passive income on the capital held in wallet by users.
Focus on… some examples of liquidity mining protocols
- Uniswap, the DEX par excellence in the DeFi world. In fact, Uniswap is currently in first place with a blocked value (TVL) of approximately 6.14 billion USD. Inside, users are rewarded with native UNI tokens after depositing their funds.
- Pancake Swap, the largest decentralised exchange platform in the Binance Smart Chain. Liquidity mining users receive rewards in the form of native CAKE tokens.
Focus on… Yield Farming
An interesting variant of liquidity mining is “yield farming”: the two practices often used as synonyms differ in the fact that a “yield farmer”, using proprietary strategies, is constantly engaged in moving his tokens across various DEX platforms in search of maximising yield.
This procedure is increasingly popular, as it no longer binds the investor to a specific platform but, on the contrary, allows greater freedom in deciding where to deposit their funds.
Benefits and Risks
The liquidity pools and the resulting liquidity mining activities have interesting advantages:
- They allow any user and investor to receive rewards passively, without having to do business or take the risks of active trading;
- The high amount of liquidity volumes present in decentralised platforms guarantees a continuous supply of liquidity to users who use decentralised services offered by DEXs.
However, they present some critical factors and risks, typical of such recent technologies and of a young and constantly evolving market, which they need to be known and understood in detail:
- Possible smart contract bugs: contracts are written by humans and can contain flaws, problems, backdoors, and so on. For this reason, smart contracts always represent a risk, albeit regularly audited;
- Liquidity pool hack, as happened twice in February 2020 on the bZx protocol, the hackers exploited smaller liquidity pools to carry out a larger market manipulation attack, managing to obtain $954,000, or in the case of the Harvest platform, where by manipulating the trading prices of stablecoins, hackers managed to steal $24 million;
- Risks related to the admin: in fact, it is not possible to be sure that a developer does not have “extra permissions” or “back doors” capable of modifying certain aspects of the code. If such “keys” existed, an admin could block the entire liquidity pool. As happened in December 2020, when the Compounder platform development team managed to steal $9.8 million from their users with a maths function that moved tokens from liquidity pools to their personal wallets;
- Impermanent Loss (IL), this phenomenon, typical of liquidity pools, especially those in which one of the two tokens is NOT a stablecoin, occurs when the price difference of the two tokens belonging to the pair changes, diverging excessively from at the initial value recorded at the time of deposit in the pool.
These price fluctuations can form significant negative changes and imbalances in the value of the tokens in the pool in the short term. However, such losses are referred to as “impermanent” as they are only actually realised if and when the liquidity provider withdraws the funds from the pool.
Since cryptographic tokens are very volatile assets, the prices that have undergone significant changes during their stay in the pool could return to the original value at which they were deposited and therefore make the potential losses deriving from the Impermanent Loss vain.
In addition to this “natural price absorption”, the phenomenon can be greatly mitigated, especially in pools where there are many exchanges and high returns, by the commissions recognized to the user providing liquidity.
It should be noted that the phenomenon of Impermanent Loss does not persist on liquidity pools that employ pairs in which a stablecoin is present (e.g., USDT / ETH, BUSD / CAKE), since the latter being “stable by definition” and not subject to significant price fluctuations, the divergence between the prices of the two tokens is not significant.
This feature makes joining these types of pools much safer, although less profitable.
Source: Bankor Network
Impermanent loss as the price of ETH changes, starting from 100 USD per ETH. As can be seen from the graph, when the market price of ETH increases or decreases, there are different amounts of loss, for example if the price of ETH quadruples (4x) there is a loss of 20%.
Since the phenomenon of Impermanent Loss represents one of the most typical and perturbing elements of joining pools, especially from an investment perspective, we report below some strategies aimed at supporting qualified investors in the objective of mitigating or avoiding the effects of the “loss impermanent “on its assets:
- Avoid very volatile liquidity pools, depositing tokens in liquidity pools with stablecoins, or those who prefer assets whose value does not fluctuate excessively based on market demand. Less volatility of the tokens underlying the pool, reduces the risk of IL, while also reducing the yield;
- Provide liquidity to unilateral staking pools. In this way, the possibility of an impermanent loss is greatly reduced if you deposit your tokens in staking pools, which allow you to block a single type of activity, providing rewards for the amount placed inside them. Basically, you do not participate in the market by providing both the pool needed tokens but only one of the two needed tokens is blocked.
- Adhering to “irregular” liquidity pools: these are deposits that employ token ratios other than the typical 50/50. For example, Balancer allows you to customise the pool by adding tokens in different ratios, such as 95/5, 80/20, 60/40 and so on. These reports have several implications in terms of impermanent loss. As an example, consider the case of an 80/20 AAVE / ETH pool. Since LPs are more exposed to AAVE (80% of the pool), if the price of the same were to increase compared to the price of ETH, there would be, in proportion, a lower IL than that which would have occurred with a 50/50 AAVE pool. / ETH.
Staking Vs Liquidity Mining
In conclusion, starting from our previous analysis we have provided an overview of the main types of Passive Income applicable to those users who hold cryptocurrencies and want to put them to good use: staking and liquidity mining.
It is therefore natural to ask which of these two strategies we could apply to a cryptocurrency portfolio and, if these services represent an ephemeral trend or are destined to become an integral and permanent part of this new industry?
According to our research, the very rapid growth of these technologies, and with them passive revenues, is justified by the great importance of these services within the DeFi ecosystem. The concept of liquidity pool and liquidity mining / yield farming represent the essence of decentralised finance services, as staking represents the new frontier of mining:
- staking allows you to validate new blocks and keep a blockchain efficient in a simpler and more effective way than the classic PoW, therefore it acts at an infrastructural level, on the network;
liquidity mining guarantees the necessary funds so that exchanges on DEXs take place in maximum efficiency and in several market conditions. Therefore, it acts on a higher layer, in terms of services that can be provided by the protocols.
Source: Zilliqa
In conclusion, the choice of one activity rather than another depends on the investor’s risk appetite and objectives.
Parameterizing these DeFi strategies to classic finance, which classifies investments taking into account the “time horizon” variable, an investor interested in a medium-long term strategy, and therefore subject to a lower risk component, could orient himself on the activity of staking.
On the contrary, an investor who is more oriented towards short to medium-term returns might opt for liquidity mining protocols by choosing and diversifying token pairs to feed different liquidity pools. Obviously, we always need to take into account the need to implement a correct risk management strategy in order to contain the effects of volatility and impairment loss.
