This article is part 2 of my “Liquidity for All” series.
Let’s do a brief but realistic recap of part 1: Liquidity Pools are created to support trading between two assets (eg. ETH-USDC). Either asset can be traded in the pool using “Automated Market Makers”, which are essentially algorithms that replace traditional “order books”. This enables 24/7 decentralized trading or “swapping” between the two underlying assets, without reliance on active buyers and sellers.
Liquidity Providers (LPs) deposit funds into liquidity pools to support trading between the two assets, and are primarily rewarded from swap fees.
In order to maintain the balance of assets in the pool (remember the downfall of the Evil Nintendo Exchange?), investors must stake an equal amount of each asset (eg. 1 ETH and 3000 USDC) into “Liquidity Provider” (LP) tokens that represent their percentage ownership of the pool and its associated rewards (eg. 0.01 ETH-USDC LP). But after “depositing” LP tokens into a liquidity pool, however, thing get a little complicated.
Pool Rebalancing
Liquidity pools follow the important “constant product” formula x * y = k, which are illustrated with Coin-Rupee transactions in part 1. This has many implications, the most important of which is that the ratio of underlying tokens in a LP token changes with market prices. Let’s see this in action:
This phenomenon is commonly referred to as “impermanent loss”, since the LP ratio could possibly return the value at the time you deposited into the pool. But the term is extremely misleading since the losses are no less “permanent” than if one were holding the individual assets. I prefer the term “divergent” loss and will use it throughout this article.
Divergence
All non-stablecoin crypto assets are subject to significant price changes. This must be accounted for when investing in liquidity positions. As demonstrated above, we are now dealing with two correlated variables: market prices and ratio of tokens. The “exposure”, or impact of price changes, is entirely based on the assets for which one is providing liquidity.
For example, a liquidity position could consist of:
- 2 Stablecoins (USDC-USDT LP)
- 1 Stablecoin and 1 Volatile Token (USDC-ETH LP)
- 2 Volatile Tokens (ETH-UNI LP)
The general rule of thumb is: if an assets price increases, then its ratio in LP tokens decreases.
Things get far more complicated when one removes stablecoins from the equation. Try this “Impermanent Loss Calculator” that provides estimations of divergent loss caused by price changes. The following set of humorous graphics from Twitter user Fiskiantes that illustrates the main takeaways:
Relatively proportional movement in both assets is optimal, since the LP ratio (x * y = k) stays roughly the same. We can sum it up with the following:
Liquidity positions enable us to earn from transaction volume as well as price changes, but they react to market circumstances much differently than simply holding the individual underlying assets.
In the next article, we expand on these classifications of liquidity into a more robust taxonomy using real market examples. So head over to part 3 “Liquidity for Adults: A Proposed Taxonomy” here.
