Liquidity Pool Investing – How To Profit From Liquidity Pools

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Liquidity Pools

Liquidity pools (LPs) (smart contracts) are pools that hold 1 or more tokens or coins in one pool. This pool is created by users like you and me, by giving our funds/money/tokens to the pool in a set ratio. Usually, the ratio is 50/50, meaning that you will give for example USDC the same amount you give ETH. 

With a 50/50 ratio, you are giving USDC by the value of ETH’s current price in the market. Meaning that if ETH is valued at $4,000, and you want to provide 1 ETH to the pool, you also need to give $4,000 USDDC to the pool too. This will give the pool liquidity, meaning money.

When a liquidity pool has a lot of liquidity trading can happen inside the pool and when trading happens, fees are generated and the fees will be given to the LP owners. Giving you profit for making the trade possible and also giving you profit for keeping the LP alive. Remember that the deeper (more TVL (Total Value Locked)) liquidity a pool has the more likely people will use that pool but also participate in the pool.

I recommend you watch this video to understand liquidity pools:

Total Value Locked In A Liquidity Pool

The total value locked (TVL) is the numeric value of how much money is locked inside the liquidity pool. If the TVL is high it could mean lower yield as there are more users participating in the pool and such the rewards are split with multiple users. A higher yield is usually possible with lower TVL but that also creates the situation where the usage of the pool might not be a pleasant experience as there might be higher slippage requirements.

When you see a high TVL value in a pool, we do not know for certain whether the pool just got bigger or the value of the tokens increased. This is something worth noting as this will create a ripple effect in other metrics too.

Total Value Locked In DeFi And DEX’s

We now know that the TVL value can be the number of tokens or the price value of the tokens. So when we see a high overall TVL value in a DEX (decentralized exchange) we don’t know if it’s because of a bull run or because there are a lot of users using the DEX.

So when we invest in a DEX, what metric can we use to know whether it will be a good long-term investment?

What this information also creates is a possible misinterpretation of the value a blockchain has or is experiencing. When using services like Defillama, we can see that blockchains have a TVL value and some are growing and some are decreasing, but we are not certain if a chain is for example growing because of user adoption or because of the market price.

This information applies to LP pools that have ALTCOIN/ALTCOIN pairs. If the pool has ALTCOIN/STABLECOIN pair, then the TVL is more accurate as the ALTCOINS are switched automatically to stablecoins to keep the price of the altcoin the same as in other marketplaces (more below in the AMM chapter).

Terra ecosystems TVL grew by roughly 10% in TVL, but we are not sure how much was it because of the added $450M in the Anchor protocol.

Automated Market Makers

Whenever the price of one of the tokens changes, the inner mechanics of AMM come to play. A system called constant product market maker makes sure that the ratio of the tokens stays the same, meaning that USDC/ETH LP has a 50/50 ratio of the number of tokens in the pool. If ETH’s price goes up, it means that people are buying ETH more, making the price go up. Because the less ETH there is in the pool, the price must go up as it’s becoming rare in the pool. If there’s more ETH in the pool, the price goes down as it’s less rare in the pool.

As the pool needs to keep a set ratio (Bancor has a liquid ratio instead fixed in some of the pools), the AMM is able to calculate the price for each asset and if there’s a stablecoin involved it only calculates for the one asset which price is fluctuating.

I suggest you watch this video to understand AMM completely and liquidity pools completely:

Earning With Liquidity Pools

Liquidity pool price variation:

liquidity_pool_investing_LP_mechanism
Losing money with liquidity pools, the impermanent loss (image source) – modified

To quickly explain the image. If you deposit tokens A and B to an LP, and neither of the tokens price change, you are looking at the point 100% (#1). If one or both of the tokens’ price drops, you are looking at the point of -100% (#2). If one of the tokens value goes up, then you are looking at the point of -25% (assuming the price increase is 5x (500%)) (#3).

#1 Situation, Both Tokens Price Stays The Same

In this scenario, you will not lose money (assuming the stablecoin holds its peg). Pools that offer this kind of situation are usually pools that have ONLY stablecoins in them.

#2 Situation, One Or Both Tokens Price Goes Down

In this situation, you will lose money. If the tokens’ price goes down, you will lose money because the value of the assets is depreciating in value. Even if you would STABLECOIN/ALTCOIN pair you would still lose money.

#3 Situation, One Of The Tokens Price Goes Up

In situation, you will also lose money, as it would be more rewarding to just hold the tokens in your wallet rather than see the price of the token go up inside LP. This applies only if you have STABLECOIN/ALTCOIN pair. If you would have ALTCOIN/ALTCOIN pair and BOTH go up, you win money. In all other scenarios, you will lose money.

How To Profit From Liquidity Pools

Now that we know that liquidity pools in their base structure (without fees or rewards calculated) will result in a loss more than likely. Now we need to figure out when is LP profitable or is it ever?

If a token goes up in value 5x and we lose 25% of value in our initial deposit when thinking impermanent loss (IL). That is only if the token goes up 5x in value, what if it goes more, then obviously the losses would be even bigger and almost in a linear fashion.

What we have to keep in mind when investing in an LP is that we should only try to invest (provide money) in pools that go up regarding the tokens value, and we also have to be certain that it goes up in value. When the value of the token goes down, then we have to carefully calculate whether the fees and rewards will cover the loss in tokens value and in the case of impermanent loss.

liquidity_pool_investing_LP_mechanism_2
How liquidity pools work and when you lose money and how much

If the price doubles in value for the altcoin, then you would lose 5,7% instead of just holding the token. If the value of the altcoin is cut in half (-50%), then you would lose 5,7% and of course, the price depreciation if you decided to remove funds from the LP and sell to stablecoins, instead of just holding the token in a wallet.

If the price goes up too much, the losses are harder and harder to recoup from the rewards. So how do we calculate the profitability of an LP?

If we know that participating in an LP is more or less a loss-and-loss game, then how can we win. This is where rewards come in. AVAX/MIM pool has a varying reward APR%, but it’s something around 40% and on top of that you will get JOE tokens if you do LP farming. JOE tokens are inflationary and thus might not have value in the future, so we should focus on the token pair. AVAX will more than likely increase in price and can increase quite a lot in a year. AVAX can do 5x gains in a year, so at this point, we are losing 25%, but as we get 40% APR, then we could be 15% in profit after a year and probably even more.

High APY And APR In Liquidity Pools (The 2X Rule)

As we know there are plenty of LPs’ that have insane APY or APR and on top of that, we have yield aggregators like Beefy Finance and Yield Wolf. So now that we know we lose in almost every case when going into LPs’, then we have to make sure that the APY and APR cover the loss of IL (impermanent loss). 

After studying a lot and calculating different scenarios, it seems that even with a massive 50% drop in price would still be ok, if the APR (yearly) is (in the case of 50% price drop) roughly 70% and APY is roughly 100%. So roughly speaking the APY should be around 2X for the expected price drop for you to get your initial investment back with zero to little profit.

This also translates (roughly calculated) that the daily APY should be roughly 2X in comparison to the price drop experienced in a day for you to be profitable on that given day. 

The 2X rule is a general metric and not precise as calculating the precise values would be pretty hard as we have to take into account the daily APY, daily price appreciation and depreciation, and the number of days invested.

With daily compounding, the amount of tokens is always compounded and the loss of income has to be calculated based on the new daily value of the tokens. So to simplify things, the 2X rule is accurate enough for me.

What Happens If Liquidity Pool Goes To Zero

In a balanced pool (50/50 token ratio), the tokens price when went to zero will make the pool such that you can’t withdraw funds from it. What happens to your tokens, you still have those tokens and the LP token, but the amount of money you will withdraw from the pool is 0. Meaning that while you would probably get the tokens back, the value of the tokens would be 0.

If there’s a STABLECOIN/ALTCOIN pair, then the value of the other token would go super high compared to the STABLECOIN, but the issue comes when you try to profit from that. Because when you are the last person withdrawing funds from the LP pool, then there’s no LP pool left for you to interact with. Meaning that you are left with your STABLECOIN and ALTCOIN, which you can’t sell because there’s no liquidity to make the sell.

Remember that while tokens have value, the market decides what value they have. While you own an LP token and that LP token has those two tokens inside it, you will get those tokens (not guaranteed) but the tokens themselves might not have value.

Weight Of The Pool

Usually, the situation is that the pool has 50/50 exposure to each token in the pool. However, the ratio of the token inside the pool could be something different too, like we see with the Grape finance protocol below:

GRAPE-MIM-LP_liquidity_pool_weighting
GRPAE-MIM-LP (liquidity pool) pool weighting (source)

Pool creators set the pool’s initial parameters, including:

  • Number of reserve tokens – a pool can be created with an unlimited # of tokens (e.g., ETH/DAI/BNT)
  • Reserve weights – each token can be set to make up 0.0001%-100% of the pool (e.g., 33% ETH, 33% DAI, 33% BNT)
  • Liquidity provider fee – percentage fee applied to each trade (can be any %)

The weighting might not always be visible to a liquidity provider (user) so if you add liquidity to the pool at 01.00 PM and withdraw your funds from the liquidity pool at 01.01 PM, it could be that you do not get the same amount of tokens you just 1 minute ago deposited and that’s because the ratio inside the pool isn’t 50/50 but something else.

Conclusion

When we know that you will lose money if the price of a token goes up or down. Then we should try to find pools that have either very high APR/APY% (remember that APR and APY go down the more TVL is locked = more participants = fewer rewards) or that have low price volatility.

If the price of a token goes up or down is not the thing we should care about. What we should care about is the rewards, APR/APY%, and the strength of the protocol. Meaning that when you are investing in a project if the project dumps altogether, then even the high reward and the low price volatility (though it would be high if a project dumps) don’t matter.

So all things considered, the strength of the project is the only fact that matters when doing LP investing. Especially when and if we are investing in low market cap projects (that usually offer those high APR and APY).

If however, we are investing in high-quality projects like AVAX, SOL, LUNA to name a few, then the rewards determine a lot whether or not you want to get in an LP. In this scenario, we have to remember that if a coin does 10x, we do not profit from that, but also if a coin does -50%, then the rewards cover the losses when given enough time.

And if you remember the price at which you entered the LP then you might even make quite a nice profit after a bear market, taking into account that you invested in an LP at ATH (all-time high). Which could actually make a pretty darn good strategy to invest into the liquidity pool when the tokens price is ATH and wait for the whole bear market and accrue rewards that whole time and sell the LP tokens when the price reaches the level you entered the LP in the first place.

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Written By Juha Ekman

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