The easiest way to learn a new concept is to write about it. And, that’s why I am doing it. We all are pretty excited (well, I assumed) that LeoFinance is launching wLEO ( an ERC 20 token) and joining the DeFi craze that has swept the crypto space lately. It is always good to join the bandwagon the market is after but do your own due diligence before making your decisions to take part in the liquidity pool.
I am pretty new to the crypto-space. So, you can imagine that I am like any other newbie trying to figure out the terminologies used by crypto experts. Since I am excited about wLEO and the potential to become one of the liquidity providers in the initial pool, I figured it is necessary for me to know the associated risks.
One of the terminologies/concepts that caught my attention was that of “impermanent loss”. This has been thrown around a lot in almost all articles that define/describe defi and yield farming.
I am describing some of the basic concepts so that non experts on Leofinance may benefit.
Automated Market Maker (AMM)
For beginners like me, it is daunting to understand what AMM is.
In centralized exchanges like Binance, Coinbase there are market makers who ensure there are enough liquid assets to enable trading through an orderbook. The order book includes all orders set by traders like us which helps to match those trade orders.
However, AMMs are decentralized and do not have market makers. As the name suggests, AMMs pool liquidity from various users (like us) and ensure trading as desired by traders. Uniswap is the unicorn of AMMs but there are many others (curve, balancer, bancor).
It is critical for these AMMs to ensure they have enough liquidity. If not, they will not be able to serve their customers. So, the success of these AMMs (uniswap, curve, balancer) depend on users’ participation in their liquidity pool. Since liquidity is so important, these AMMs would incentivize users to lock their assets in their platform.
Liquidity Providers (LPs)
Users who provide assets to AMMs to ensure trading in those platforms are Liquidity Providers (LP). Anybody can be a liquidity provider. If you decide to wrap Leo to create wLEO and back that up with 50% ETH and submit that on Uniswap as the Leofinance team is planning to do then you are one of the LPs on Uniswap.
How AMMs function?
The way these AMMs work varies between each platform. Uniswap has its own mathematical formula to automatically create a market for traders. If you want to be a LP for wLEO on Uniswap, then you are required to contribute to the swap asset pool in a 50-50 allocation (wLEO and ETH) with the underlying equation of X*Y=K.
In simpler terms, the platform ensures that the total value of the asset pair is constant all the time despite the price appreciation or depreciation of each token in the pair.
The rigidity of the equation or the way it functions could create a situation where appreciation of one of the tokens.
Impermanent loss (IL)
Impermanent Loss happens when the price of tokens inside an AMM diverge in any direction (appreciate or depreciate). It is a temporary loss of funds unless the LP decides to withdraw their liquidity at that appreciation/depreciation point.
Example:
For a 50-50 ETH and USDT pair, an LP should provide an equal value of both tokens (1USDT500 = 2ETH250 = 1000 USD)
Since ETH is volatile and can go up or down in external markets, AMMs like Uniswap need to adjust the ETH price to match others and maintain the constant product as per their mathematical formula.
IL is the opportunity cost when providing liquidity. It is impermanent because it is associated with the market price and can go up or down depending on the market.
What’s the benefit for LPs?
The LPs collect money from trading fees. On Uniswap, each trade on your liquidity pool pays a 0.3% fee that is distributed to the LPs of that pool based on their contribution.
In addition, there are additional incentives in the form of native tokens (liquidity mining) provided by AMMs. The Leofinance is offering additional bonus tokens for LPs for providing liquidity to the wLEO-ETH pool on Uniswap. If the value of the native tokens appreciates in value and if there are bounties offered, the loss incurred from Impermanent Loss would not matter much.
So, do you think you are ready for wLEO-ETC Uniswap pool?
I am still doing my research :)
For readers who are interested to know more, here are the links that I went through on AMMs and IL
https://medium.com/@pintail/uniswap-a-good-deal-for-liquidity-providers-104c0b6816f2
https://medium.com/@pintail/understanding-uniswap-returns-cc593f3499ef
https://cryptobriefing.com/how-to-yield-farm-uniswap-not-get-rekt/
https://blog.bancor.network/beginners-guide-to-getting-rekt-by-impermanent-loss-7c9510cb2f22
https://www.reddit.com/r/UniSwap/comments/deqwg7/eli5_what_is_impermanent_loss/