DeFi Liquidity Pairs, “impermanent loss” & very permanent profit
If you're in the blockchain space and use decentralized exchanges/done some yield farming, chances are that you've heard of Liquidity Pairs.
The main risk you've probably heard all around the place is the dreaded impermanent loss (😨), a mysterious part of how liquidity pairs work and can lose you tons of money! The thing is, impermanent loss is actually not that bad, and in fact can be good for you!
Liquidity Pairs (I'll shorten it just to pairs later) are composed of 2 tokens, token A and token B.
When you make an LP, you put 2 amounts of those tokens with equivalent value and you receive a share of the pool. These tokens are put into liquidity pools to help other people trade, and you get fees in exchange for doing so.
What is impermanent loss even?
Impermanent Loss (IL) is a term used to mean the difference between the value of holding 2 tokens in your wallet and holding 2 tokens in an LP.
Due to asset rebalancing (a trait of Uniswap-based LPs, keeping the market value of those two tokens equally balanced)*, you earn less than you would just by holding those 2 tokens.
Asset rebalancing can be used for DCA
Asset rebalancing is the cause of Impermanent Loss, but how does asset rebalancing work? The truth is much simpler than you might think. Let’s say you have an LP pair of BTC-BNB at a starting ratio of 50:50 at entry. The actual prices of the assets are not important when considering asset rebalancing, only their relative price to each other. So instead of 50:50, let’s simplify the ratio to 1:1. If BTC price rises 10% more relative to BNB price, then 1.1:1 becomes the new ratio before asset rebalancing. Now, the AMM needs to rebalance this into 1:1, so how does it do that? Simple: it sells BTC and buys more BNB, until the value ratio becomes 1:1. As BTC price continues to rise relative to BNB, the AMM continues selling BTC and buying BNB. When the price of BTC moves back down relative to BNB, the AMM does the opposite; it sells BNB and buys BTC. – AlpacaFinance
This is similar to a strategy for investing: dollar cost averaging! When BTC price goes up compared to BNB, the AMM is rebalanced by arbitrageurs and sells some BTC to put into BNB, and vice versa.
This is also a way of automatic portfolio rebalancing where you earn fees for doing so!
I'm going to provide liquidity now! Woohooo!
If you want to, do it! It supports your project of choice by giving them liquidity, it earns you fees (that usually outpace any IL) and if they have a farm for earning extra yield (sometimes platforms subsidize liquidity providers by giving them extra money), that's awesome.
However, you should be careful of massive yields from farms, as it is a sign of an inflationary token which is designed to go down over time. Exercise proper caution, DYOR, look for audits and use trusted platforms like Autofarm or Beefy.
Tips for beginners providing liquidity
- Pair it with a trusted stablecoin for easier tracking
- Enter pools with enough liquidity (>500K$ or so)
- Do your own research, especially look for audits
- Use yield optimizers like Beefy which compound farm yields
- Don't put in more than you can afford to lose
- Have fun!
Source
Footnotes
*originally said it was arbitrageurs balancing it, this is actually an intrinsic trait of uniswap LPs. arbitrageurs balance the price between 2 exchanges when there is a difference, that's arbitrage
tags here to not bother anyone: #defi #dex #uniswap #investing #liquidity #farming