It appears that every time someone talks about a liquidity pool in these forums somebody always chirps up and asks what impermanent loss is.
There’s a million guides but they can be very complicated to understand. I intend here to put it as simply as possible so that all newcomers can try to wrap their heads around it. I’m going to use friendly apples and oranges for my analogies 😊
And just so we’re all clear on the acronyms I’ll be using.
DEX = Decentralised Exchange LP = Liquidity Pool IL = Impermenant Loss APR = Annual Percentage Rate
Let’s break it down!
— What is a liquidity pool? -
A liquidity pool is some where you ‘pool’ two tokens together and provide them as a sort of funding to help other users perform trades or swaps. Think about it. If someone has an apple and they want to swap it for an orange at the shop the shop keeper (DEX) needs to have oranges in stock to do so. Who provides the shop keeper the oranges? The liquidity pool provider does, AKA you!
— But why would we provide the shopkeeper with oranges or apples? -
The shop keeper (DEX) needs apples and oranges to perform these trades so in return for you lending them your assets you will be rewarded. Usually either more apples or oranges. Some shop keepers (DEX’s) will issue extra rewards on top. Maybe in the form of their own native currency, alongside the apples or oranges.
How many apples and oranges to I have to lend? -
As many or as little as you like! But there are two things to consider. The more you lend, the bigger your reward will be! If you lend so much that out of all the shops apples and oranges 50% belong to you, you will receive 50% of the shops total rewards. NEAT! You have to lend the shop an equal value of oranges and apples. So if an apple is $1 and an orange is 10c. You will have to lend 10 oranges for every 1 apple. EASY!
— How much rewards will you get? -
Each shop (DEX) have varying rewards for different types of apples or oranges. The shop usually only has a set number of apples or oranges they can use for rewards per year and so the more people lending their assets, the less rewards there are to share between all the lenders per year. This is known as APR. Some APRs are very high 100% plus, some are low at around 10%. Usually the APR can tell you two things. How many apples or oranges the shop has per year for their rewards or how many/ few lenders there are in the LP.
Can I take my apples and oranges out whenever I want? -
Usually YES! As a liquidity pool provider you can usually take your apples and oranges out from the shop whenever you like. But be careful of something called impermenant loss! (IL)
— What is impermenant loss? -
Let’s say you have 100 apples and 100 oranges, each fruit is worth 50c. You lend them to the shop to start earning more apples as a reward, a total of $100 has been put into the liquidity pool.
Now let’s say that apples go up to $1 each and oranges are still 50c. You’ve got $150 in the LP right? Wrong!
You see the shop has to have 50% apples and 50% oranges, in value, so that it has enough of each to swap whenever someone wants to buy or swap them.
This means that now you have less apples and more oranges in your LP. Something like 150 oranges and 50 apples. In this case, you may now have a total of $125 in you LP position (150x50c + 50x$1).
This is less than if you had just kept your apples and oranges at home because you would have 100 oranges ($50) and 100 apples ($100). $150 total.
So you now have a $25 impermenant loss.
— Why is it called impermenant? -
Because you haven’t really lost the money. PHEW! Not yet… If you then decide to take your apples and oranges out of the shop you will only get 150 oranges and 50 apples. At this moment your IL becomes a realised loss because you have $25 less apples and oranges than if you’d just held onto them.
— Why would anyone do this then? -
Well! Let’s imagine two things. Firstly:
Your apples and oranges have been at the shop for 1 year and the APR was 100%, your reward is oranges… You have earned an extra 100 oranges for lending your assets to the shop. So you now have 250 oranges at 50c each and 50 apples at $1 each. That’s a total of $175! So your impermenant loss has been offset by your rewards. It’s worth noting that this isn’t always the case, depending on your shops APR and time you’ve been a LP provider, your oranges may only be worth a fraction of this… Crypto is volatile and prices can go anywhere!
Secondly: If the apples and oranges stay at 50c each or even go the $1 each, you will still have the same amount of apples or oranges in the LP as when you started.
— So if the prices change of assets that’s when impermenant loss can happen? -
YES! When either price goes up or down a balance of value must exist in the LP. So to keep the balance the amount of apples or oranges has to change.
— So…
Liquidity pools can exist outside of DEX’s but this is where they are largely found. There’s all different kinds for different types of apples and oranges, different rewards rates, different risks and different platforms. It’s important to understand what you’re getting involved in before joining but they are an important sector for crypto and the world of decentralised finance!
As ever be careful, do your homework and enjoy your apples and oranges! 😊
PS. This is a very loose guide, I’d advise doing heavy external research before jumping in!
