LP Academy
A brief introductory course on being a liquidity provider
Why provide liquidity?
Providing liquidity on decentralized exchanges is a complex financial instrument that can be used in a variety of ways. For some, it's a simple tool to create yield on your assets. For advanced users, it can be a market hedge, a way to transfer one asset to another, a long-term investment, or even a way to influence markets.
For the purposes of this guide, we'll be focusing on the most basic goal of LPing: Creating yield for the liquidity provider.
Liquidity and TVL
A critical statistic to evaluate when providing liquidity is Total Value Locked (TVL). This number indicates how much liquidity has been deposited in a vault/pool at any given time.
TVL can be viewed as an indicator of how much value can be extracted from a particular pool/vault. If a vault with $2,000,000 TVL and a vault with $10,000 TVL are producing the same amount of fees, the $10,000 vault would be significantly more profitable to enter, as there is a much higher fee/TVL ratio. More fees spread between fewer people.
In the example below, different variables on the same pairs create vastly different TVLs. The market determines which vaults create more value.
Liquidity can be allocated or misallocated. Under concentrated liquidity, LPs get to choose the range and depth of liquidity they provide to a vault/pool. If the user sets liquidity out of range or misallocates liquidity, it doesn't generate fees. It will still appear as TVL though, so this can mislead users into thinking a pool's fees are being diluted more than they are.
In the image above, Gamma is concentrating liquidity around the current price. This proper allocation allows Gamma to collect the majority of the fees created.
By using Gamma, you are letting a liquidity manager manage the vault in which you are participating. Therefore, for the purposes of this beginner guide, it's safe to assume Gamma is doing its best to keep your funds producing fees. But, evaluating the allocation of liquidity helps the user understand the dynamics of that particular liquidity spread.
Liquidity can also be either at equilibrium or imbalanced. At equilibrium, the amount of money in a particular pool/vault is creating a small but stable return in fees for the LP. An overbalanced pool has too many funds in it. The yield is not compensating for the risk. An underbalanced pool has too few funds in it. There is too much yield for how much risk there is. Expect funds to be withdrawn from an overbalanced pool and funds to be deposited into an underbalanced pool.
In the example below, MATIC is paired with two stablecoins: USDC and USDT. The fees/volume of USDC is significantly better, even with more overall TVL. The funds in MATIC / USDC are also significantly better allocated.
LPs generally try to capitalize on these imbalances by entering pools they think are or will be underbalanced in the future by allocating their liquidity correctly. Below, we'll discuss some variables that change the balance of pools/vaults.
Volume and Fees
Volume is the amount of assets traded for a given unit of time. Every transaction produces fees. So, a higher volume means higher fees. Lower volumes mean lower fees.
TVL will increase in response to an increase in volume and fees.
Volatility and Impermanent Loss
Volatility is the degree of variation of a trading price for a given unit of time. Volatility causes impermanent loss. So, higher volatility means higher impermanent loss. Lower volatility means lower impermanent loss.
TVL will decrease in response to an increase in volatility and impermanent loss.
The Role of Incentives
Incentives are issued tokens to users for providing liquidity to a pool/vault. Incentives provide both an improved strategy and more yield for LPs.
TVL will increase in response to an increase in incentives.
Gas and Service Fees
Gas and service fees are both payments made to blockchain operators and protocol operators for using services like trading, swapping, depositing, and more. They vary widely on different blockchains and protocols.
TVL will decrease with higher gas and service fees.
Feedback Loops
Nothing happens in liquidity markets in a vacuum. An increase in volume is usually associated with an increase in volatility. Incentives usually increase volumes on incentivized pairs. An overall drop in TVL is often associated with drops in volume. Volume and Volatility both increase gas fees on blockchains. Low volatility will concentrate LPs around a specific price, which dilutes fee production for each user.
It's important to understand that these concepts all buffer each other and help keep extremes in control.
Pair Types
There are a variety of pair types that LPs can deposit into when providing liquidity. Each pair is unique, but there is some ability to classify them.
One way to evaluate a pair is if the assets are stable or volatile by design. A stablecoin (like USDC), paired with another stablecoin (like USDT), would form a stable-stable pair. One would expect a pair like this to be not volatile and have low potential fee production. That's why you usually see very low fee tiers like 0.01% on these pairs. On the flip side, a volatile-volatile pair can be very volatile and have a very high potential fee production. It's not uncommon to see fee tiers for these pairs at 1.00%.
Another way to evaluate a pair is if the assets are correlated or uncorrelated. Stable-stable pairs are generally correlated, as stablecoin's purpose is to peg near an asset price. If one stablecoin depegs, it can affect the others and depeg them as well. Likewise, a volatile-volatile pair like BTC-ETH has often had a strong historical correlation, as they are the two largest assets in the market. Both of them are strongly affected by macroeconomic market trends rather than individual price action.
It's important to note there are many exceptions to this. USDC has depegged while USDT has remained stable. BTC and ETH have had moments of highly divergent price action. A correlated pair is not always so over time.
Lastly, an important metric to consider when evaluating a pair is where it can be traded. A pair like ETH-USDC can be traded on both centralized and decentralized exchanges on a variety of blockchains.
The demand for the pair is huge. In contrast, a pair like GAMMA-ETH is much more restricted. GAMMA can currently only be traded on Uniswap V3, on Ethereum mainnet. LPs must take this into consideration when deciding whether to provide liquidity.
Conclusion
Although there are many advanced strategies with LPing, prioritizing undercapitalized pools is a time-tested rule that both beginner LPs and advanced LPs use to create returns.
Stay tuned for more topics added to the LP Academy!
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