If you haven't already, check out our article on AMM and Liquidity providers, as it'll provide valuable context for the following article.
Decentralized finance protocols such as Solanax or Solend are Solana-based liquidity protocols that have seen a huge influx of volume and liquidity; they allow the average investors to become market makers and, in return, are rewarded with trading fees.
These people are called liquidity providers, and the act of earning passive income from providing liquidity is called yield farming.
So, you earn money by providing liquidity, so what's the catch? Well, it's a thing called impermanent loss, and everyone who plans on providing liquidity needs to understand it.
Impermanent loss happens when you provide liquidity to a liquidity pool and the price of the crypto assets that you deposit changes compared to the price you deposited them at. The larger the change in price, the higher the risk of impermanent loss. The loss being a reduction in value from the point of deposit to when you withdraw.
It all depends on the type of coins you're trading with; if pools contain assets that remain within a small price range, they'll be less likely to experience impermanent loss; stablecoins are good examples of this as they remain within very tight price levels.
So why would you want to provide liquidity if there's a chance you will experience impermanent loss? Well, the trading fees that liquidity providers receive can be worth the risk as protocols such as uni swap charges 0.3% per trade, which goes directly to the LPs (liquidity providers), ultimately counteracting the downside to being exposed to impermanent loss.
Stephen deposits 1 SOL and 100 ADA into a liquidity pool; let's pretend they're of the same value. This would mean that 1 SOL is worth 100 ADA at the time Stephen deposits his coins, which would be around 200USD at the time of writing.
Other investors have deposited a total of 9 SOL and 900 ADA into the liquidity pool, which means that Stephen has provided 10% of the pool, bringing the overall liquidity value to 10,000.
If the price of your 1 SOL increases in price to around the equivalent of 400 ADA, traders will add ADA into the pool and remove SOL until the ratio reflects the current price. The price of assets is determined by the ratio between them in the pool. Liquidity remains constant at around 10,000 while the ratio of assets fluctuates.
Considering price has now changed, there are now 5 SOL and 2000 ADA in the liquidity pool. If Stephen decides to withdraw his initial investment, he'd expect to see a share of 10%, which would calculate to 0.5SOL and 200 ADA, coming in at 400 USD, which would be a tidy profit of $200 of her initial deposit.
But, it's not entirely a good thing because if he had just held on to his 1 SOL and 200 ADA, the combined value would come out at 500 USD.
This would be an example of impermanent loss, albeit a small one, but if you're looking to provide liquidity on a larger scale, the loss could be significant. But, the fees that Stephen earns on the liquidity he has provided could easily outweigh the risk of impermanent loss, resulting in an overall profit.
It's also important to note that impermanent loss happens regardless of the direction the market moves; it only cares about the price ratio relative to the time of deposit.
If you'd like to see a visual guide on impermanent loss, check out this video.
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