In the world of decentralized finance (DeFi), liquidity is one of the most important aspects of a healthy ecosystem.
Without liquidity there can be no market activity and without market activity there can be no price discovery or price availability. One way to get liquidity in the DeFi space is to use a liquidity pool.
Liquidity pools are a DeFi market-making investment tool that does not rely on traditional, well-funded market makers. While order books for traditional markets are efficient, crypto markets charge fees that make it difficult for market makers to provide liquidity profitably. If you become a liquidity provider by depositing your tokens into a liquidity pool, you can then trade like a market maker and receive rewards for the fees collected from all trading activities.
Let’s take a look at how liquidity pools work on WX.Network.
In September 2022, the APY (Annual Percentage Return) for providing liquidity for the USDC/USDT trading pair on WX.Network was up to 43%. Demand for liquidity pools comes from market participants who need a pool of available liquidity to swap USDC for USDT or vice versa. Users who own both USDC and USDT can help create a market by depositing their tokens into a liquidity pool and earning up to 43% APY in return.
After depositing their USDC and USDT tokens into the liquidity pool, users will receive a “USDCUSDTLP” LP token representing their share of the tokens in the pool. When users leave a pool, their LP token is burned in exchange for the tokens originally deposited and the rewards accrued from providing liquidity. The larger the pool, the more fees are generated and the more rewards are paid to liquidity providers.
Liquidity providers’ revenue can come from a variety of sources, such as a percentage of the platform’s trading fees and staking rewards based on the length of time they are willing to keep their share as liquidity on the protocol.
What are yield farming premiums?
The rewards generated from liquidity pools can come from two sources:
- Bonus yield that the protocol offers to motivate users to provide liquidity
- Fees generated by market participants executing swaps
Yield farming is the strategic “harvesting” of these rewards, creating a win-win scenario for users and DeFi protocols. Liquidity providers receive yield in the form of a governance token or a yield token and protocols receive decentralized bootstrapping liquidity. The greater the proportion of liquidity a provider has contributed to an LP, the greater the return it can earn from its LP. Yield farming has become a popular passive income strategy for those who know how to use LP rewards.
With yield farming becoming more popular these days, it’s important to do your own research and understand the basics before participating. Here are some factors to consider:
- incentives: What are the motivations behind this project? What is offered on LPs? How long will these incentives last? Is the project sustainable without them?
- log fees: Are there log fees? how much do they cost Where does this income go?
- tokenomics: How is the token distribution? How is inflation handled by the protocol? Is there a buyback/burn mechanism?
- guide: Who decides on the protocol? How decentralized is it? What are the processes for community contributions?
- risk: What are the risks associated with this project? Is it overcollateralised? What happens if Flash crashes?
Before engaging in yield farming on any platform, you should 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, this return typically comes from protocol incentives. At launch, the protocol typically withholds a small percentage of the token supply as an incentive. The earliest LPs are paid in these native tokens as a reward for providing liquidity to the protocol.
Once the liquidity pool has gained some traction, the rewards shift from incentives to service delivery. There is usually a fee set for each pool, which is considered the log fee. The fees generated by the trading activity in these pools are redistributed proportionally to the LPs in this pool and become a source of income going forward.
LPs that provide liquidity early own a larger share of the pool and can collect more rewards. As the number of LPs and liquidity in a pool grows over time, the return each LP generates decreases. Ultimately, yield farmers can exit their position and reallocate their funds to 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 greatest 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 causes LPs to sell their less valuable token to buy the more expensive one, resulting in a loss.
Long story short, impermanent loss highlights the difference in how much better liquidity providers would have had by simply holding their tokens rather than providing liquidity in a pool.
This happens when the price of an invested token in one liquidity pool changes in any direction relative to another. The greater the change, the greater the fleeting loss. Ephemeral losses are referred to as ephemeral or unrealized because they are not recognized 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, the value of a token at a point in time when it lost value may be less than when you provided it, and the loss becomes permanent.
How fleeting loss worksSuppose you deposit 100 USDC and 5 WAVES into the WAVES/USDC pool (total 200 USD, at the price of 1 WAVES = 20 USDC). When the market price of WAVES drops to 15 USDC, the AMM (Automated Market Maker) algorithm automatically rebalances the ratio of tokens in the pool and changes their value according to the following formulas: USDC amount × WAVES amount = constant By calculating, we get that the value of your tokens in the pool is $173.2 (86.6 USDC and 5.77 WAVES). If you kept the tokens in your wallet instead, the value of the tokens would be $175 (100 USDC and 5 WAVES). In this example, the temporary loss is $175 – $173.2 = $1.8. |
A temporary loss is an inherent risk in providing liquidity to pools and is directly related to a trading pair’s volatility. To minimize potential losses, users can invest in stable pools like USDT/USDC.
So if the temporary loss can eat away at profit, then what do liquidity providers choose to provide liquidity in the first place?
To find the answer, keep the following ideas in mind:
- The price of LP tokens is slowly increasing over time anyway. Therefore, even in the event of a temporary loss, holders can still make profits provided that the temporary loss is less than the increase in LP token price based on trading activity.
- Staking LP Tokens provides rewards in the form of WX Tokens.
- WX token staking provides additional WX token rewards while increasing LP token staking rewards across all pools.
All of these sources of income can make investing in liquidity pools profitable and in many cases offset the potential downside of a temporary loss.
WX.Network Liquidity Pools
Currently, Waves has a number of different pools that allow users to provide liquidity and earn rewards on the WX Network’s Decentralized Exchange (DEX). For example, the EGG/USDC pool may offer a much higher return than other pools, but the high volatility of the token pair means an increased risk of temporary loss for inexperienced users.
WX.Network also offers pools with lower rewards – and risk – that offer a more consistent return without the hassle of active management. The USDC/USDT and USDT/USDC pools have the lowest risk as the price of stablecoins fluctuates very little and there is a very low risk of temporary losses.
Stablecoin pools expose holders to the risk of a depegging event. Depending on how they are designed, stablecoins are prone to depegging. A depeg occurs when the price of the stablecoin falls below the price of the asset to which it is pegged for an extended period of time.
The next frontier of finance
Providing liquidity with different tokens in different combinations entails a spectrum of risk-reward trade-offs. As with any cutting-edge technology, financial technology represents a whole new way of investing and should be approached with caution and awareness
A common way of experimenting with Waves.Exchange liquidity pools is to diversify risk by diversifying a portfolio between positions in high yield liquidity pools with APYs and lower yield liquidity pools with APYs. By diversifying the portfolio, the downside is minimized while maintaining the potential for significant outperformance to the upside.
Together, protocols like Waves.Exchange and the LPs that support their liquidity pools share the risks and rewards that come with building the foundations of tomorrow’s unstoppable, decentralized crypto economy.
Visit WX.Network’s Liquidity Pools to find a pool that matches your risk tolerance and start earning rewards today.
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