Pooling is committing liquidity to an exchange pair on a decentralised exchange. This means, you do not exchange one token for another, but you deposit both tokens - equally valued - to the liquidity pool. With liquidity providers earning a fraction of the pair generated fees, depending on the portion of the total liquidity provided by participants, this makes you a return for your tokens - minus any gas fees when transferring your tokens to and from the pool - similar to what you would earn by lending your assets. The key in this strategy is to commit liquidity to a pair that is already quite popular, and generates enough commissions for the pool participants.
We decided to experiment by commiting equal value of tokens in one low transaction pair (where we would have a larger share in the pool), and a high transaction pair (where we would have a much lower share in the pool). We selected BAT and Loopring LRC against ETH, so our experiment would have some practical significance for our Publish0x readers. Since this was for experimental purposes only, we only committed some $15 value of tokens for each experiment, so our results would be comparable.
After 10 days, here are the results for each pair:
On ETH-LRC pair, the low transaction one, our Ethereum was decreased by 0.0243 ETH, and our Loopring was increased by 7.3625. This means people were swapping Loopring LRCs for ETH rather than ETH for Loopring LRCs, thus decreasing the overall ETH available in the pool, compared to LRC. In a pair, always one side is increasing and the other decreasing, even with stablecoins. The trend may be reversing from time to time, but the overall principle holds true at all times. So, to leave out any exchange rate gains or losses - as they do not play a role in our experiment - the sum of value difference is our earnings from transactions. Drumroll, please! 2 whole cents! $0.021, or 0.14% of the invested value to be accurate. That equals to an annualised return (ARR) of 5% (if all plays as by now), which is again a good return, compared to most investments.
Results are far better for the popular ETH-BAT pair. Our ETH was increased by 0.0048805, and our BAT decreased by 2.2456, obviously due to the recent increased demand for BAT, during the upward movement of the BAT exchange rate. The sum of the difference is over 51 cents - $0.5141, or 3.37% to be accurate. However, if we were to make assumptions on an annualised return, this should be taken with a pinch of salt, as the transaction volume was unusually high in the past 4-5 days, due to the upward trend of the BAT dollar price. Although such bursts of volume may be happening often in the future, we would decrease this 10-day return by 2/3, to normalise the volume. Thus, the anticipated annualised return, would be some 40% on the committed tokens value.
Could you be making a higher return with larger investments?
The short answer to this question is 'possibly, but not significantly'. This is because these are established pairs with quite some liquidity committed. Unless you have several hundreds of thousands of dollars valued in both sides of each pair in order to get a significant share in the pool, the annualised percentage return for your committed tokens wouldn't be significantly affected by committing more tokens, rather then fewer tokens.
What happens if one or both tokens of the pair take a nosedive?
Again, there is not one answer to this question. If one side of the pair you have invested is a stablecoin, it's the other side you have to worry about - in this case however, you have higher transaction volumes and therefore higher fees generated.
If one side is increasing while the other is decreasing, in most cases, you will be getting the average return on the pair value, as if you had them stored in a cold wallet, plus the portion of the transaction fees earned. In our ETH-BAT pair, for the period ETH lost about 12% and BAT gained around 23%, an average of 6% gain. A trader might have converted his/her ETH into a stablecoin, or even more aggressively into BAT. This would mean an overall gain anywhere from 11% to 22%, if you count in gas fees. With an overall return of around 8%, including our earnings from commission income, you can consider this as a not entirely missed opportunity.
If both sides are moving downwards, and you expect them to continue so for some days, you can always withdraw your tokens and convert them to some stablecoin. In our ETH-LRC pair, the overall valuation, including earnings from commission fees, is at around 10%, when ETH lost about 12% and LRC lost some 26%, or about 19% overall. So, despite our measly 0.15% return in net earnings, we managed to cut our potential overall loss by 50%, just like in our ETH-BAT pool our potential overall gains were cut by 50%.
It's like letting the crowd do the trading for you.