Liquidity is a fancy word for money that is available. Liquidity pools provide the assets needed for automated transactions in DeFi or decentralized finance. In traditional finance, an intermediary like Fidelity or TD Ameritrade creates a marketplace for buyers and sellers to trade and receives fees for this service, but in DeFi, users deposit assets into a pool managed by a smart contract. This means users can trade directly with the pool without the need for an intermediary.
A small fee is charged for each transaction, which is paid out to the liquidity providers as a reward. The more liquidity provided, the larger the percentage of rewards they receive. Traders save on exchange fees, and anyone can provide liquidity and earn rewards as passive income.
How liquidity pools work
Typically, two assets are placed in a pool at a 50:50 value ratio, and an algorithm controls the price of each asset based on how much of it is in the pool. As users trade assets in the pool, the algorithm known as “Automated Market Maker” adjusts the prices of the assets to maintain the initial value ratio.
For example, if a liquidity pool contains 100 blue tokens at $5 each and 500 white tokens at $1 each, the value of each asset in the pool is the same even though the composition of the pool is 1 blue token for every 5 white tokens.
If blue tokens suddenly become very popular and people start selling their white tokens to buy blue tokens, the price of blue tokens will increase gradually to maintain the value ratio. The price of white tokens could also go down as more are deposited into the pool in exchange for blue tokens. This is known as price impact, the impact of transactions in the pool on the price of assets in the pool.
What does this mean for liquidity providers?
When liquidity providers deposit assets into a pool, they receive LP tokens as a representation of their contribution. They are entitled to the percentage of liquidity they have made available to the overall pool. The more liquidity in the pool, the fewer assets are subject to the price impact, but that also means liquidity providers receive a smaller share of rewards.
It is also important to note how liquidity is used for these trades as this is how rewards are generated. Liquidity is distributed to allow trading at any price point, from $0 to $10,000 to infinity and beyond. However, most trades occur within a fairly specific price range, say between $0.99 and $1.01, so liquidity providers only make money on the trades that occur within that price range. This means that much of their capital is underutilized and the rewards are much less compared to what would be possible with their full deposit.
In addition, if liquidity providers withdraw their deposits after the composition and price of the assets in the pool have changed, there may be less value left than when they started. This is known as fleeting loss. It is ephemeral as users don’t notice the loss until they withdraw. It is possible that pool conditions could change in their favor and they could regain this loss in the future, but of course there are no guarantees. There are calculators to help you estimate any temporary losses before withdrawing a deposit. However, this is one of the biggest hurdles for liquidity providers.
How ICHI can help
ICHI offers the provision of liquidity for individual assets. Users can deposit just one asset in a vault and let ICHI’s concentrated liquidity management strategies maximize their capital efficiency. Concentrated liquidity allows users to set a specific price range in which to distribute their liquidity. This means higher trading fees, but also constant monitoring of trading trends and paying gas fees to adjust the price range for the most efficient use of your liquidity. In other words, if the trade is outside of your set price range, you earn nothing.
ICHI safes take away the learning time, costly fees and stress by actively monitoring these positions so you don’t have to. You stay in control of your wealth and let ICHI do the rest while you decide what token rewards you want to receive. Learn more about ICHI’s Greedy Liquidity Protocol and how it can help mitigate risk and maximize profits. If you have any questions, join us on our Discord!
We have created a video to explain this topic: https://youtu.be/5QrbodqnCb4
Thank you for reading and let us know if you have any questions.
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