Intro to Liquidity Pooling (LP) in DeFi

infernal_toast
4 min readFeb 16, 2021

One of the greatest innovations in blockchain technology recently, the AMM, is causing the entire sector to grow exponentially. The Decentralized AMM, or Automated Market Maker, is a special type of Financial Exchange that runs on a blockchain like the Ethereum Network.

An AMM is an exchange such as Uniswap.io or Sushiswap.fi that allows users to trade ERC20 tokens for other ERC20 tokens using a simplified interface. Users trade their tokens against a pool of liquidity, a vault of token currency that is locked inside of the AMM Smart Contract. For example, imagine the 0xBTC-ETH pair on Uniswap.

https://info.uniswap.org/pair/0xc12c4c3e0008b838f75189bfb39283467cf6e5b3

In the Uniswap Smart Contract, there exists a vault containing 156,017 0xBTC and 52.79 ETH. The price of 0xBTC is determined by this ratio, linearly. Therefore the price ratio to buy or sell 0xBTC is (156017/52.79) = 2955.42 0xBTC / 1ETH . The Uniswap vault is it’s own ‘Price Oracle’.

Users can trade 2955.42 0xBTC for 1 ETH on the front interface, or they can trade 1 ETH for 2955.42. Since the trade itself will change the ratios of the assets in the vault, there is a small fee to estimate price slippage which is based on the resulting new price ratio (new asset supply ratios in the vault) that will exist after the trade is complete. Additionally, a 0.3% fee is skimmed off the trade and put into the vault to reward the Liquidity Poolers for staking their currency into this vault. It is auto-compounding.

Liquidity Poolers are Ethereum users who decide to stake their ERC20 currency inside of the Uniswap backend in order to earn interest (the trading fees) on their capital over time. Anyone can LP using the Uniswap front-end (‘Pool’ tab) or by using a simple Zapper front-end such as the one at https://farm.mineabletokens.com.

When you Pool your liquidity into a Uniswap AMM pool, that pool handles trades for a pairing of two assets. You have to supply equal amounts of value of each currency. This is based on the price oracle, based on the ratio of the assets already in the exchange’s vaults. (The first person to pool liquidity for a vault gets to choose the price ratio and thus the initial price of the asset which changes due to trades)

As a receipt for your pooled liquidity, you will receive LP-tokens. These do not do anything by default, they just let you redeem the currencies you deposited in the Smart Contract vault at a later time. Since you own a constant proportion of the vault assets (pool share %), you will be able to withdraw the same amount of assets as you put in + the 0.03% trading fees that have been piling up in the vault. The only risk to you are the Impermanent Losses!

You are of course price-exposed to the two assets that you are Staking into the pool. Furthermore, if the two assets you are Staking end up changing in price relative to each other, the vault (which you own a share of) will have more of the less valued asset and less of the higher valued asset. This is why you ideally should pool two currencies which will :

  1. Ideally have very high trading volume to maximize fees
  2. Ideally have stable price in relation to one another
  3. Ideally both go up in value, together, over time

There are thus some good Pools to use that have different risks:

  1. The DAI-USDC pool has no impermanent loss but you aren’t exposed to crypto (ouch!)
  2. The wBTC-RenBTC pool has no impermanent loss assuming synthetic stability and you are exposed to BTC
  3. The 0xBTC-ETH pool is commonly used by 0xBTC miners to acquire ETH for gas in exchange for their SHA256-powered mint() transactions that earn them new 0xBTC

Now that capital can be used to earn trading fees on decentralized exchanges, the blockchain world is forever changed. For example, if you believe assets will trade sideways, you can LP on those assets and earn money even in a flat yet volatile market. The earning potential of Ethereum users has increased in a huge way.

Just see all the revenue that Uniswap and Sushiswap are earning for their poolers: https://cryptofees.info/

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