Liquidity mining has become a huge aspect of the pioneering De-Fi space that continues to grow in not only size, but also in innovation. Despite the "amazing returns" that many platforms tout, being a liquidity provider comes with a set of risks that must be handled according to your own personal risk tolerance. Throughout this article, I will explain the basics of LP mining including the pros, cons, risks, and various types of pools and potential strategies to overcome these cons and minimize risk, but also maximize rewards! I will attempt to do this in a clear and concise manner, for ease of reading and for the sake of simplicity, as I've noticed many other articles on this topic can become very tedious and unconcise.
So then, what exactly is a liquidity pool?
Liquidity pools are the very foundation of most Decentralized Exchanges (DEX) and are the very heart and soul of De-Fi. Essentially, liquidity pools are an amalgam of funds from a great multitude of different individuals which are locked into a smart contract in order to facilitate the many processes and actions one may need to perform in the De-Fi landscape. Uniswap, 1inch, Pancake Swap, Bake Swap, Balancer, etc. - these are all DEXs that utilize LPs as the backbone for the entire network.
Typically, liquidity pools require two tokens as a pair, locked into the smart contract in equal amounts. These are 50:50 liquidity pools and they are the currently the most common, being the only pool type available on Uniswap and Pancake Swap (I'll get to the other types of pools later). In exchange for becoming a liquidity provider and locking your funds into the smart contract, the provider is given LP tokens which represent their stake in the pool. These LP tokens earn modest rewards in trading fees, proportional to their share of the pool. Usually the trading fee is approximately 0.30% depending on the exchange. This is then added to the pool, thereby increasing the value of each LP token. On top of that, to further incentivize liquidity providers and to help mitigate impermanent loss, providers are usually offered an option to stake their LP tokens for more rewards!
For example, on Pancake Swap, I have $500 BNB and $500 CAKE locked into a pool and received about 5 CAKE-LP tokens (which are slowly increasing in value due to trade fees). Instead of just holding the CAKE-LP in my wallet, I can lock the CAKE-LP tokens into another smart contract which will then earn me extra rewards in the form of $CAKE.
Automated Market Makers (AMMs)
The main technology behind the huge spurt of Swap DEXs that have been popping up like weeds, are Automated Market Makers (AMM). AMMs have rid us of the need for an order book. By removing the need for a buyer to sell to, or a seller to buy from, many tokens can become much, much more liquid. So now, instead of trading P2P, you would be trading against the liquidity pool with the pair you are swapping.
Wow! So why doesn't everybody become a liquidity provider and farm rewards?
Risk vs Reward
Well, it isn't all rainbows and sunshine. Any offer of high return comes with high risk. Besides the inherent risk of depositing your funds into a smart contract (bugs, hacks, etc), the main culprit here is Impermanent Loss. I will tell you how you can minimize impermanent loss and I will also touch on some other ways you may be losing out by providing liquidity in a 50:50 liquidity pool.
Impermanent loss occurs when the prices of the paired assets change.
For my 1st example, I will use a TRX/USDT pool. Say you bought 1000 TRX at $0.5 each and you want to add it to the TRX/USDT pool to reap passive income. You decide to swap half your TRX (500 TRX) for USDT because the passive rewards sound nice, even though you firmly believe that TRX will gain in value. Now you have 500 TRX and 250 USDT totaling $500. A month passes and you are overjoyed to see that TRX now has a value of one whole dollar!!! But wait.. As the TRX in the pool increases in value and since the USDT is stable at its price, the pool's ratio balance becomes off kilter. In order to bring the pool back to a 50:50 ratio, the AMM sells TRX for USDT until balance is achieved, which means you now have even less TRX and more USDT, but in a lesser amount than you would have had if it was still TRX.
This loss is called "impermanent" because of the fact that if TRX went back down in value to $0.50, then you would still have 500 TRX and 250 USDT, but then you would have missed out on the 2x gain you potentially could have made by not having it in he pool. Now, I also want you to consider this. If you never swapped your 1000 TRX for USDT, your $500 TRX would be worth $1000 TRX, whereas in the yield farm, if TRX gains 100% your total value would be $750 - impermanent loss (maybe 5%). This, is what I'd call opportunity cost.
When I first became a liquidity providers, a lot of the articles I read blatantly stated that the SAFEST liquidity pool to participate in, is one with a stablecoin pair, but, in a way, that is incorrect.
The BEST possible strategy to not suffer impermanent loss is to provide liquidity for a pair that moves together ie ETH/WETH, BTC/pBTC, etc. OR to provide for non 50:50 pools, like the ones available on Balancer, which will help to mitigate risk. I had an opportunity cost of nearly $5,000 because I chose to sell half my TRX for USDJ to provide liquidity, as I was a novice at the time and had no personal insight into what the actual benefits and risks of being an LP. Suddenly it occurred to me that stablecoin pools minimize risk only slightly because it's unlikely the stablecoin will lose value, but it also GREATLY minimizes gains because whatever amount you have in the stablecoin won't appreciate in value over time and the opportunity cost of leaving the USDT in a pool rather than holding an asset appreciating in value, can be quite large.
But I had also participated in another pool, the TRX/JST pool, and as I calculated my loss in that pool, it all began to come together.
For the sake of simplicity, I once again, have 1000 TRX at $0.5 totaling $500 TRX. I swap 500 TRX for 1000 JST at $0.25 for a total of $250 TRX and $250 JST and I add it to the yield farm. A month passes and JST has gained 300% and TRX has gained 300%. What would the impermanent loss be? ZERO.
Since the value between the two assets have the same ratio at this point in time, the impermanent loss is zero and you just went from $500 starting, to $1500 + trading fee rewards.
Now pretend we're in the same situation, except this time JST gained 300% but TRX only gained 200%. The impermanent loss here would only be from that extra 100% gained by JST so that JST would be converted to TRX, but the gains would be MUCH larger than a stablecoin pair and the impermanent loss would be MUCH lesser. The most optimal solution for liquidity providers to maximize gain without taking on more risk, is to provide liquidity to a pair that moves in tandem with each other! I use the TRX ecosystem as my examples because in the recent bull run, you could see that the more TRON grows, the more TRC20s grow and vice versa! Their value is organically tied to each other, so the success of one usually helps boost the other!
All in all, liquidity mining can be a great way to participate in the De-Fi ecosystem and to earn a passive income. Mitigate your risks and maximize your rewards! Trade smart. De-Fi smart. Make money smart. Consider a variety of options before settling on one. If you think an asset will increase drastically, should you put it in a pool or should you simply hold it? If you expect low volatility, would it be more profitable to provide liquidity, or to hold it? Create a proper plan of attack and have goals in mind and you will have no problem profiting in the pioneering De-Fi space.
Remember, this is not financial advice and is strictly to help educate folks. Please do your own research separate from this article and never invest more than you can afford to lose! Feel free to comment or message me if you have any questions, or if you wish to provide further insight. This is my very first article here on publish0x and I know this is a frequently covered topic, but I've read 10+ different articles on the topic and none seemed to really clarify LP strategy until I had participated in LP farming myself; so it is my hope that this article will assist people who are in the same place I was before I started.
Happy farming! :)