Note: I am not an expert and this is not financial advice. Always do your own research and remember, I’m just some bloke on the internet and I could be wrong.
The cryptocurrency space has recently seen an almost cyclical influx of new users aiming to make gains from the latest industrial trend: yield farming. However, many of them end up getting rekt (losing their money).
Reasons for losses vary wildly from rug pulls (scams) to a simple lack of knowledge on the risks involved. While I cannot personally do anything about all of Aladdin’s carpets flying away into the abyss, I figure I can try and help people understand the concepts of liquidity pools, yield farming and staking.
The first point to explain is the concept of liquidity pools. In their essence, they provide the foundation for yield farming. Think of a liquidity pool as a mishmash of a supermarket’s stock room and cash reserve. When you enter your supermarket you expect for three things:
1. They will have your item in stock
2. The price of your item will mirror that of other supermarkets
3. They will have the means to allow you to pay for your item and refund your change from their cash reserve
Imagine you went to your preferred supermarket and they had the item you want but they had such little supply of it that they are charging triple the price of their competitors in order to increase their own profit. You’d just walk out the door and go somewhere else, right?
Now imagine you go to your supermarket and they have your product at the market price of £5 but you only have a £50 note, and they have no change. Same result, you’d leave and go elsewhere.
This is, in essence, the concept of liquidity: having enough stock on both sides of the trade to enable the exchange to happen.
What’s the relevance?
Cryptocurrency and stock exchanges traditionally suffer from the issue of centralisation (one person controlling everything).
This is because someone has to provide the crypto/stock which is to be traded in the first place. This is called liquidity. An exchange which has no liquidity is about as much use as a toddler’s piggy bank.
Low liquidity can cause a whole load of issues which range from a simple lack of any trading, to slippage which is so high that the price is wildly inaccurate. Slippage can be thought of as the percentage by which a trade price has parted from an asset’s true price.
While this isn’t an issue in the traditional stock market, which is run by insanely wealthy hedge fund managers whom, most likely, benefit from financial inbreeding, it is an issue in an industry which values decentralised (no single entity owns it) systems.
This is why liquidity pools exist. They allow anyone to provide funds to a decentralised exchange and receive a cut of the fees generated from the pair they deposit to.
The idea is that you provide equal amounts (in USD value) of token A and token B so that traders can switch between the two frictionlessly. As more people provide liquidity larger trades can occur with less price slippage.
This concept provides the grounds for fully decentralised exchanges such as Uniswap. And for the latest craze in the crypto industry: yield farming.
So what exactly is yield farming? Simply put, yield farming is the process of locking your assets in a liquidity pool in order to receive a return on them. However, it is not without its own risks. And this is what I think a lot of people are mistaken about.
Hacks and scams aside, I didn’t learn the risks of being a liquidity provider until I had already made what is called an impermanent loss.
And it is this experience which has convinced me to write this article, to try and help others avoid making losses on through misunderstanding.
What is Impermanent Loss?
To understand impermanent loss we need to take a quick step back to the role of a liquidity provider.
When you become a liquidity provider you provide your liquidity to a market of your choice and in return you receive a share of the market (and the fees it generates). To explain what this means we need to get into some numbers.
Let’s say we have Token A and Token B, both worth $100, and we deposit them into a John Swap’s liquidity pool. In return for our tokens we get an LP (Liquidity Provider) token called JSW-LP. We decide to forget about it for a couple months and go about our usual daily routines.
When we check on our investment we notice that Token A is still worth $100 and Token B is now worth $200, yay, right? Maybe.
Remember, we essentially sold our supply of Token A and Token B for a token called JSW-LP. And when we bought our JSW-LP we did so with both tokens at equal value, or at a ratio of 1:1. Now that Token B is worth double its deposit value our ratio is actually 1:0.5 — 1 Token A is worth 0.5 Token B.
What this means is that we might have incurred an impermanent loss. If we were to withdraw our liquidity right now we would receive 1 Token A, 0.5 Token B and whatever fees we had earned from the pool.
Generally speaking you would hope the fees you receive from the pool offset any IL incurred. But it is not always the case and it is important to be aware of. It is also important to remember that you haven’t actually incurred your loss until you withdraw your liquidity.
Staking, like yield farming, offers users financial rewards for allowing a smart contract to essentially hold their funds. Reasons for offering staking rewards vary wildly from governance to creating a sense of scarcity.
Unlike in yield farming however, staking does not pose the risk of an impermanent loss occurring. This means that you should always leave a staking pool with more tokens regardless of what the asset’s price does. Whether the tokens are actually worth anything in USD is another issue entirely.
As a result of the lower risk and lack of trading fee generation, staking pools usually offer lower returns than liquidity pools.
So there you have it. A brief and, hopefully, accurate explanation of the latest craze to hit the crypto space.
Love, peace and happiness.