Liquidity is a crucial foundation for the success of any decentralized exchange (DEX). However, despite its importance, understanding the basics of liquidity provisioning (LP’ing) can be a daunting process. In this blog post, we will provide an introduction to the basics of liquidity provisioning and DEXs, outlining how they can be used to facilitate a more efficient and secure place to craft your ideal crypto portfolio. We will also explore the advantages and disadvantages of liquidity provisioning on DEXs, and how you can get started with it today.
The most common type of DEX, known as an automated market maker (AMM), allows users to buy and sell different tokens in a trustless environment. It uses a smart contract-based liquidity pool and algorithmic pricing system to match trades, eliminating the need for a central matching engine. By utilizing an algorithmic approach to execute trades, AMMs offer users fast, secure, and low-cost transactions while removing the need for centralized control. The most popular DEXs, such as Uniswap, have handled over a trillion dollars in volume since their inception.
The price quoted by an AMM is all dependent on which prices are quoted by the liquidity providers (LPs). For instance, an LP may look to place liquidity in the WETH/USDC 300bp pool because they own those two assets. The first step of LPing is to decide which price ranges you believe WETH will stay in across a certain time horizon. For instance, based on the previous 6 months, you may believe that WETH will stay between $1000-$1800 for the next 6 months. Next, you deposit liquidity that is evenly distributed across that price range, and receive an NFT token that represents the attributes of your position. For all trades that occur in your price range, and in turn use the liquidity you provided, the more fees your position will accrue. Thus, a more concentrated range means that you will earn more fees, since you are providing deeper liquidity to traders who are executing swaps in that range. Consequently, if the price moves out of range, then you would have been better off holding the underlying assets than LPing.
LPs may also choose their price ranges based on their inventory, which is the set of assets they own. For instance, if 100% of their wallet is WETH, then they can only provide liquidity above the current price range. When the price of WETH increases into the specified range, the AMM will allow users to trade USDC for the WETH supplied by that LPs position, turning their inventory into some part USDC and some part WETH. On the other hand, if their inventory was 100% USDC, then they are forced to provide liquidity at ranges below the current price, allowing the AMM to sell their WETH for USDC when the price of WETH decreases into their range. Lastly, if the LP owns a mix of WETH and USDC, they may choose to specify a set of price ranges that involve the current price. While inventory plays some part in deciding price ranges, the primary factor still boils down to the LP’s outlook on the future price of the asset.
Yield for an LP position on an AMM is calculated by taking the total amount of fees generated from liquidity provider activities and dividing it by the total value of assets (liquidity) locked in the price ranges that were used for the trades. Every time a user swaps on an AMM, a portion of their transaction––known as the pool fee––is distributed to LPs that provided liquidity at that price; this is known as having your liquidity be in-range. This calculation provides a yield percentage which can be used to evaluate the overall performance of an LP’s portfolio. The calculation is dynamic and changes as more capital is added, withdrawn, or exchanged on the AMM. It is important to note that LPing should not be treated as a fixed income product, as the yields are typically more volatile than lending or staking. In general, a higher yield percentage indicates better performance, but this should be balanced against the risks associated with the liquidity pool in question; one such risk is the volatility of the underlying asset.
Ultimately, LPing into AMMs can be a great way to craft any crypto portfolio. When done well, LPing into AMMs allows users to dynamically add or remove liquidity from a pool in order to adjust their token holdings, thus creating a custom portfolio tailored to their goals. Furthermore, the fees collected from providing liquidity can be used to diversify and modify the portfolio, allowing users to adjust their weightings in the desired proportions. The automated nature of AMMs managing liquidity can make it easier for users to keep track of their portfolio, enabling them to more easily monitor their investments over time without having to manually execute transactions.
Managing tick ranges and knowing when to rebalance your position can be a highly complex and tedious process. After all, market making has historically been done best by high-frequency trading firms with brilliant traders tracking the markets throughout the day.
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