Liquidity Providing is important because it allows for trustless trading. If the liquidity pools are large enough, they allow for high volume trading with limited slippage.
Most importantly, when PulseChain and Liquid Loans launch, you’ll be able to provide liquidity on pairs such as LOAN/PLS, USDL/PLS, or USDL/LOAN and earn fees.
In order to do this safely you must understand impermanent loss and how to avoid it.
Impermanent Loss is a temporary loss in value occurring when the two assets that you provide liquidity for change in price relative to each other.
If you have no idea what any of this means, check out our article on Liquidity Pools here.
An extreme example of impermanent loss would occur if you provided liquidity for two tokens and one of them went to zero.
Let’s use PLS and pUSDC (since PLS will have non-zero value and pUSDC will likely approach zero due to irredeemability on the new chain).
If this occurred, buyers and sellers would use your liquidity pool to sell all of their pUSDC for your PLS.
As a result, your pool would convert to 100% pUSDC at a price of near zero.
Impermanent loss comes into play because, hypothetically, if you never provided liquidity, you’d still be holding half of your coins as ETH and they’d have a non-zero total value.
A Liquidity Provider is an entity that decides to add one or more tokens in a liquidity pool to allow for other users to swap tokens using that pool.
For example, a liquidity provider could choose to deposit 1000 LOAN tokens and 1000 PLS tokens into a liquidity pool on PulseX.
By doing this, the liquidity provider is agreeing to allow other users to swap LOAN token for PLS coin or PLS coin for LOAN token within a certain ratio.
Liquidity providers are incentivized to do this despite risk of impermanent loss because of the fees generated every time somebody swaps in their pool.
For example, let’s say a user wants to swap 1000 PLS for 1000 LOAN token using a pool with a 0.3% fee. The trader will be able to do so, but the smart contract will deliver 0.3% of the 1000 PLS (which equals 3 PLS) to the liquidity provider.
Impermanent loss, just like most concepts in crypto, can seem daunting at first but is actually very easy to understand.
Let’s continue with the PLS/LOAN example.
Let’s say on September 1st, the price of LOAN token and PLS coin are both $1.
Now, on October 1st, the price of PLS stayed at $1 and the price LOAN rose to $1.5.
If you had held 500 LOAN token and 500 PLS coin without providing liquidity, you tokens would now be worth $1,250
If you had provided liquidity, you’d be holding 408.25 LOAN and 612.37 PLS coin, which would now be worth $1,224.74.
The result would be an impermanent loss of 2.02%. In other words, you’d have more value if you had just held the tokens without providing liquidity. However, the fees you make in the process could help offset the impermanent loss.
If you need help with calculating impermanent loss, you can use our impermanent loss calculator:
If you don’t have a calculator, here’s how you could do it by hand.
It is important to note that a calculator cannot help you determine future impermanent loss. Nobody has a crystal ball for future price action, so impermanent loss can only be calculated in hindsight.
So since we cannot predict impermanent loss, what are some strategies to avoid it all together?
The goal of a liquidity provider is to generate as many fees as possible while mitigating risk of impermanent loss. There are two ways to avoid impermanent loss:
Impermanent loss is possible with stablecoins if the stablecoins you hold lose their peg.
To avoid this issue make sure to choose stablecoins that have strong redemption mechanisms and are worth less than the collateral backing them.
For example, USDL and LUSD are stablecoins who always have more than 110% collateral ratio in the form of PLS and ETH, respectively. They have built-in redemption mechanisms which ensure that $1 of the stablecoin is always redeemable for $1 worth of collateral.
Additionally, USDC, USDT, and DAI all have had inconsistent histories of holding their peg to one dollar. If one of these went to zero and you held on LP, you’d end up with no cumulative value at all.
Examples of stablecoin pairs which can experience impermanent loss are UST or AUSD. These stablecoins had flaws in their designs which resulted in them crashing to near zero.
Overall, if both stablecoin hold their peg in your liquidity pair, LPing with stablecoins can be a safe way to earn yield on your dry powder.
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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.
Connor is a US-based digital marketer and writer. He has a diverse military and academic background, but developed a passion over the years for blockchain and DeFi because of their potential to provide censorship resistance and financial freedom. Connor is dedicated to educating and inspiring others in the space, and is an active member and investor in the Ethereum, Hex, and PulseChain communities.
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