For those looking to earn a return on capital in DeFi, providing liquidity to decentralized exchanges(DEXs) is a popular choice.
In this process, liquidity providers (LPs) deposit token pairs to earn a percentage of the transaction fees charged to liquidity pool users who seek to exchange the two assets. As one asset is traded for another, the relative prices of the assets shift, determining a new market rate for both. In return for providing assets (liquidity) to the pool, liquidity providers are given LP tokens. These liquidity provider tokens generate a yield based on the LP's share of the total pool liquidity. LP tokens can be redeemed for the underlying assets at any time. Additionally, decentralized exchanges may also reward LPs with governance tokens.
However, profiting as a liquidity provider involves more than simply depositing assets and collecting profits. There are numerous factors to consider when deciding whether to provide liquidity for a given asset pair, such as the pool's total volume locked (TVL), the number of trades (trade volume) per day, and the characteristics and volatility of the assets itself.
Here are five factors to understand before providing tokens to a liquidity pool on a decentralized exchange.
Knowing the TVL—the amount of liquidity in a pool—is one metric used to indicate whether the pool will be subject to significant price changes. The higher the amount of liquidity, the less susceptible a pool is to price slippage or changes in the price ratio between the two assets. This price divergence is bad for liquidity providers, as we'll explore in the section below on impermanent loss.
However, if you are early to a liquidity pool and foresee a strong future for the pool, it may make sense to enter, as you will share the fees with fewer liquidity providers.
You also want to ensure the pool is not made up primarily of whales, as they can drastically affect prices should they exit the pool.
Since LPs take a percentage of fees from each swap, more swaps means higher fees. This is why checking the daily volume of a liquidity pool is such an important factor. Make sure to look at how many trades have taken place and the directionality of the trend; is trading volume growing or declining? While market conditions vary, it's generally better if volume is constant or increasing over time, as a decrease means the LP will earn lower fees.
In addition to the volume of trading activity, LPs also want to look at the size of the trades. Currently, Uniswap v2 LPs receive 0.3% off each transaction, so fees are proportional to the size of the trade. This means a pool can have a high trading volume, but if the trades are small, the fees gained will also be small. Meanwhile, a liquidity pool with lower volume but larger trades may gain more in fees.
Knowing the ratio of trade volume to the amount of liquidity over time can help the LP understand the APY expected in a given liquidity pool. As mentioned above, for every event that occurs in a pool, LPs share a percentage of the trading fees. Thus, the higher the trading volume, the higher the potential profit an LP can make.
However, these fees can be difficult to calculate. Since the fees collected by the LP are calculated from the percentage of LP tokens owned compared to the total, users adding or removing liquidity changes the LP's total ratio. To calculate the fee, it is necessary to track not only every swap amount but all liquidity events as well, adding a layer of difficulty to any back-tested trading strategy.
When the price of the tokens in the pool moves opposite each other, LPs will experience impermanent loss. This applies whether the price change is negative or positive, and the larger the change, the more an LP is exposed to impermanent loss.
Impermanent loss is the opportunity cost a liquidity provider faces when a token's price changes relative to its pair, between the time it is deposited in a liquidity pool and when it is withdrawn. The loss is considered impermanent because liquidity providers can recover if the token pair returns to the initial exchange rate.
To generate returns as an LP, the profit earned from fees must be greater than the impermanent loss, but calculating this is an arduous and complex ordeal. Read our Investor's Guide to Impermanent Loss to learn more.
Earning a return from providing liquidity on a DEX is much more nuanced than simply depositing tokens into a random liquidity pool. Investigating a pool's TVL, trade volume, movement, and price fluctuations helps build and inform a strong LP strategy. Granular DeFi data is paramount to accurately investigating each of these factors. With actionable information, providing liquidity on a decentralized exchange can be a profitable strategy.