Decentralized exchanges — or DEXs — are exchanges that live on a blockchain, with many of the most popular ones, like Uniswap and Sushiswap, living on the Ethereum blockchain.
DEXs use smart contracts to allow users to exchange cryptos back and forth without the need for a central authority like a bank or broker, and they do not allow trading between fiat and cryptos.
How do you work?
Unlike centralized exchanges that use buy and sell orders to determine the market price, DEXs use Automated Market Makers (AMM) to create prices.
Automated market makers use smart contracts and liquidity pools to set prices. If you’ve ever wondered (or heard) how cryptos can be priced differently on different exchanges and websites, then this is why.
AMMs rely on users to lock some of their crypto in a digital wallet where it cannot be removed for some time. These coins can then be exchanged for other cryptos by traders on the DEX.
Now of course no one locks their coins for free, Liquidity Providers (LPs) earn interest on their coins based on how much they provide.
Automated market makers use the formula x * y = k, where k is a constant. If we add 50 tomatoes and 50 potatoes to form a liquidity pool, k must always equal 2,500. The total value of the two usually has to be the same, so let’s say they both cost a dollar. That means 1 tomato equals 1 potato and we have a 50/50 split.
Suppose someone wants to trade 10 potatoes for tomatoes. You might think, “Oh, easy, one on one”. Well, not exactly. What happened, I go to the AMM and give it my 10 potatoes and it recalculates the exchange. We now have 50 tomatoes and 60 potatoes in the pool, but that’s not equal to 2,500.
So since we have 60 potatoes that need to multiply with our 2,500 tomatoes, we simply divide 2,500 by 60, which equals 41.667. So my 10 potatoes were worth 8,333 tomatoes.
Liquidity Pools
When you add liquidity to a liquidity pool as a provider, you typically add liquidity at the ratio at which it is currently being traded. This prevents LPs from adding liquidity in price-moving ways and means you need to add two types of crypto when providing liquidity.
Depending on how “exotic” the pair of cryptos is, the higher the fee traders incur for exchanging the coins, and the more the LPs earn. LPs earn based on the amount they provide. So if I make 10% of a pool, I get 10% in fees every time the two are swapped.
Prices may vary, but at Uniswap, stable pairs can earn as little as 0.05% in fees, while exotic pairs earn up to 1%. Considering that the fees collected in the last 24 hours were $3.84 million versus $2.19 billion, providing liquidity on paper could be a very profitable proposition.
So should you provide liquidity?
Well, “on paper” and “in reality” are two very different things.
According to a study by Bancor, a decentralized trading protocol, about half of LPs on Uniswap are actually in the red. This is due to a phenomenon that has plagued DEXs called “impermanent loss” (IL).
A temporary loss occurs when the liquidity pool becomes uneven compared to its original position.
Now let’s go back to our earlier example, where 10 potatoes got us 8,333 tomatoes. When I provided this liquidity, both were worth $1 each. But what if that wasn’t the case anymore?
Let’s say the price of tomatoes went up to $2 while potatoes stayed at $1.
My stash of tomatoes and potatoes was once valued at $100 when there were 50 tomatoes and potatoes at $1 each.
However, after the exchange, the market price for tomatoes has doubled, meaning the 41,667 tomatoes remaining in the pool are now worth $83.33, while my 60 potatoes are worth $60. The value of our liquidity pool is now $143.33, which is a profit of $43.33.
But what if instead of cash we just held tomatoes and potatoes?
Well, my 50 tomatoes would be worth $100 and my 50 potatoes would be worth $50, so a total of $150.
This means if I hadn’t become an LP, I would have made $6.67 more than I did, so my impermanent loss is $6.67.
Given that half of all Uniswap liquidity providers are losing money, this means that the change in relative value between the two coins by a nickel flip is far from being much more drastic than in the example shown.
For the “stable pairs”, providing liquidity could be a good option depending on the crypto’s consensus mechanism, but you may also be better off simply staking these coins if you are looking for a long-term investment in these coins than this exchange There is no guarantee that the rate will be maintained.
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
Comments are closed.