Wrapped MetrixCoin and Liquidity Pools with Decentralized Exchanges
One such DeFi protocol used quite often in decentralized exchanges is setting up liquidity pools. Liquidity Providers, or LPs, that provide liquidity may receive an LP token generating high annualized percentage yields, called liquidity mining, aside from the trading fees. Another common practice within the DeFi ecosystem is moving or swapping assets to other protocols that have a high APY, or yield farming. Let’s take a closer look at Liquidity Pools, the benefits and risks.
Understanding Liquidity Pool
Let’s walk through a scenario revolving around a liquidity pool for SHARD and BUSD. You provide liquidity of 100 SHARD and 100 BUSD to the pool at a set price of $1.00 USD per SHARD. After several trades from others exchanging SHARD for BUSD the price of SHARD varies.
SHARD @ $1.00 = 100 SHARD + 100 BUSD
SHARD @ $0.64 = 125 SHARD + 80 BUSD
SHARD @ $1.56 = 80 SHARD + 125 BUSD
As the LP, you may receive a percentage fee from the trades and an LP token for providing the liquidity. These measures incentivize LPs for adding liquidity to a pool. However, LPs must use caution in selecting assets to which they would like to provide liquidity. If the deposited asset is volatile and the price changes, then the LP has suffered an impermanent loss. Impermanent loss is the effect where if one asset in a liquidity pool is purchased, then the price increases along the curve, but there is less of that asset in the pool. The liquidity providers own the same percentage share of the total pool meaning they now own less of the more valuable asset. A strategy to mitigate impermanent loss is by adding less volatile or stable assets to liquidity pools.
If price returns, then the pool rebalances such is often the case with stablecoins. However, if the price keeps moving the loss or opportunity cost is very much permanent. So why even take the risk? Well for one, the LP may gain more quantity of the highly priced asset. And two, LPs are rewarded with LP tokens and trading fees.
See the following additional articles on how to get started with a liquidity pool and the risks.