3 Things a DeFi Investor Needs to Know Before Apeing Into Those High Yield Liquidity Pools

Today, we’ll go through decentralized exchanges (DEX), liquidity pools (LPs) and what you’re risking when investing in an LP.

Understanding the basics to DEXes and LPs will enable you to better structure your portfolio of DeFi investments for a more asymmetric return profile.

Now, let’s dive in.

What is a Decentralized Exchange or Automated Market Maker (AMM) ?

DEXs like Uniswap, SushiSwap and Astroport work differently from centralized exchanges in that instead of a counter-party to your trades, the liquidity in the system is provided by a decentralized liquidity pool. This can have both it’s pros and cons:

Pros:

  • Automation through smart contracts can allow for more innovative DeFi strategies
  • No counter-party

Cons:

  • The liquidity in the pool determines how much slippage in price there may be. if a buyer tries to buy a large portion of what’s available in the LP, they will see their realized price rise substantially
  • There is risk of Impairment loss for those providing liquidity

How does a liquidity pool generate yield?

As a liquidity provider you often provide equal portions of 2 different currencies. For example you may provide $100 UST and $100 LUNA for a UST/LUNA Liquidity Pool.

The pool then will be used to allow buyers and sellers to quickly transact without needing to find a counterparty to their trade, ie. A buyer will buy LUNA from the pool for $X, and when a seller comes along a few mins later they will sell LUNA to the pool $(X-a) where a is the premium the liquidity pool is taking. This premium will be smaller or larger based on demand for the pool.

What is impermanent Loss in liquidity pools?

Impairment loss occurs when the prices of the two assets that you are providing liquidity for diverge strongly. The further they diverge the greater the loss (that is unable to be covered by the premium you are receiving for providing liquidity).

Examples of impermanent loss for differing divergences in price between two assets:

$LUNA/ $UST

Starting Price: $100/$1

Ending Price $150/$1–2% loss

Ending Price $200/$1–5.72% Loss

Ending Price $500/$1- 25.46% Loss

As you can see above despite the price of LUNA doubling the resulting impermanent loss was only 5.72%, but when the price increased 5X the impermanent loss increased at a greater rate. The Impermanent loss is the same for price fluctuations (in percentage terms) in both directions As a result when choosing LPs for yield, you will minimize impermanent loss by choosing 2 assets that tend to move together.

To calculate your risk check out the impermanent loss calculator at dailydefi.org.

Try Your Next Liquidity Pool!

My favorite place to find LPs (specifically for Terra) is currently through the website coinhall.com or beefy.finance for most other chains.

This post was created with Typeshare

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Entrepreneur and Investor. Focusing on Microcap Value Investing DeFi, and Web 3 deployment.

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Maaiz Khan

Maaiz Khan

Entrepreneur and Investor. Focusing on Microcap Value Investing DeFi, and Web 3 deployment.

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