Module 3.1: Providing Liquidity in DeFi
This module is dedicated to the study of liquidity in the context of decentralized finance (DeFi). We will discuss the key role of liquidity in ensuring the efficient operation of DeFi financial markets, explore how the process of providing liquidity through liquidity pools on decentralized exchanges occurs, and examine important concepts such as price slippage and impermanent loss. We will also look at strategies for minimizing risks associated with liquidity provision, including the use of lending platforms and specialized pools, to maximize returns and reduce potential losses for investors.
What is liquidity?
Liquidity is a measure of how easily an asset can be quickly sold at market price without significantly impacting its value. In the context of DeFi, liquidity is critically important as it ensures the ecosystem’s ability to handle buy-sell operations without significant delays and with minimal price slippage.
Liquidity in DeFi
In DeFi, liquidity is provided through so-called liquidity pools on decentralized exchanges, such as Uniswap on Ethereum, or StonFi and Dedust on the TON blockchain. Users who supply their assets to these pools are called liquidity providers. They often receive rewards in the form of transaction fees from trades occurring within the pool, as well as other types of rewards depending on the specific DeFi protocol.
Supplying liquidity in the world of decentralized finance (DeFi) opens up unique opportunities for investors that are not available within the traditional financial system. Let’s try to understand this process and find out what advantages it can offer.
What is liquidity provision in DeFi?
The process of providing liquidity involves depositing cryptocurrency assets into a so-called liquidity pool. Participants, providing liquidity, usually invest pairs of tokens, and the contribution is made in a proportion that matches the current exchange rate of these tokens within the pool. In return for their contribution, liquidity providers receive special LP (Liquidity Provider) tokens, which are evidence of their share in the liquidity pool. Holding LP tokens allows participants to receive a share of the fees charged by the protocol for operations within the pool.
Example of providing liquidity Consider Alice, who decides to provide liquidity to the ETH/DAI pool on the Uniswap platform. To do this, Alice deposits ETH and DAI into the pool, doing so in equal value proportion, to match the current exchange rate of these currencies within the pool. As confirmation of her contribution, Alice receives LP tokens, reflecting her share in the pool. These tokens can be used not only to manage her contribution but also to generate additional income, for example, through participation in a rewards farming program.
Managing pool share and farming Owning LP tokens opens several usage paths for Alice:
- Managing contribution: Alice can decide to withdraw her assets from the pool at any time, exchanging LP tokens back for the corresponding proportion of ETH and DAI.
- Receiving commissions: Due to operations within the pool, Alice will receive a portion of the transaction fees, distributed proportionally to her share of LP tokens.
- Farming rewards: In addition to commissions, Alice can participate in a farming program, staking her LP tokens to receive additional rewards in the form of platform tokens or other cryptocurrencies. Sometimes staking tokens is not required for farming, depending on the protocol.
Risks in liquidity provision and exchanges.
Price Slippage (Slippage)
Price slippage occurs when the actual execution price of a transaction differs from the expected one. This can be caused by insufficient liquidity in the pool at the time of the transaction.
Example: You want to buy token A for token B, expecting that the exchange rate will be 1 to 100. However, due to low liquidity in the pool, your transaction is executed at a rate of 1 to 80. This 20% slippage decreases the efficiency of your transaction.
Impermanent Loss
Impermanent loss occurs when the value of the assets supplied to the pool changes relative to each other after they were deposited. This means that if you simply held the tokens in the initial proportion in your wallet, their market value would be higher. This is one of the main risks for liquidity providers.
Example: You invested Ethereum and DAI in a liquidity pool in a ratio of 1:2000. If the price of Ethereum rises, and the new ratio becomes 1:2500, you will receive less Ethereum back if you decide to withdraw your assets from the pool, as the value of Ethereum has increased relative to DAI.
Minimizing impermanent loss
It is an important aspect of risk management for liquidity providers in DeFi. Let’s examine how to reduce this risk using various strategies involving lending platforms and specialized pools.
Combining liquidity provision with lending markets
One way to reduce the risk of impermanent loss is to combine liquidity provision with the use of lending platforms. This allows the liquidity provider to simultaneously borrow the same asset they are supplying in liquidity, thereby “freezing” its price.
Example: If you provide liquidity in the ETH/USDC pair, while simultaneously borrowing ETH on a lending platform, you effectively hedge against the rise in ETH’s price. If the price of ETH increases, your potential profit from the borrowed ETH will offset the losses from impermanent loss in the liquidity pool.
Providing liquidity in specialized single-asset pools
Another strategy is to participate in pools where liquidity is provided not in pairs, but in a single asset. This can be relevant for futures exchanges or lending platforms where users can trade with leverage.
Example: Providing liquidity in a futures exchange pool (for example, Storm Trade on TON) allows traders to use this liquidity for leveraged trades. In this case, the risk of impermanent loss is absent because liquidity is provided in a single asset. However, the yield in such pools may vary depending on the success of traders.
Providing Liquidity in Pairs with Correlated Assets
Choosing to invest in pairs with assets whose prices typically follow each other (e.g., USDT/USDC or TON/stTON) or have low volatility can reduce the potential risk of impermanent loss to zero.
Long-term liquidity provision
Considering investment in specialized pools, it’s important to consider the possibility of long-term liquidity provision. In many cases, liquidity to such pools is provided for a period of several months, which can smooth out yield fluctuations and provide a more stable income.
Regulated proportions and ranges in pools
Some protocols offer liquidity providers flexible options for managing their investments, going beyond the traditional 50/50 approach. These protocols allow adjusting the proportions of assets in liquidity pools and defining specific price ranges for participation in trading. This provides the ability to adapt to market changes, minimize risks, and strive for increased yield.
For example, if an investor anticipates the growth of a certain asset, they can choose an investment proportion different from equal, such as 1 to 5, or even provide liquidity using only one asset. This is particularly useful for those who want to maintain a larger share in a specific asset or avoid buying additional assets to create a traditional pair.
Setting trading ranges is similar to the stop-loss mechanism on traditional markets, offering liquidity providers a tool to limit participation in trading within predefined price limits. This helps avoid significant losses in volatile market conditions.
Currently, on the TON blockchain, liquidity is provided exclusively in asset pairs and without the option to choose ranges. However, with the development and updating of DeFi protocols, additional opportunities for liquidity providers can be expected, including more flexible schemes for interacting with liquidity pools, making the process even more convenient and profitable.
Conclusion
Providing liquidity in DeFi represents a powerful tool for investors looking to explore opportunities beyond the traditional financial system. It’s not just a way to participate in the development of innovative financial technologies but also a chance to earn income through commissions and rewards farming. However, as with any investment activity, key is risk management, especially regarding price slippage and impermanent losses. Thoughtful application of strategies and a deep understanding of DeFi mechanisms can help minimize risks and maximize potential profits.
All Educational modules list:
Module: 1.1 Differences between TradFi, DeFi and CeFi
Module 1.2: The History of DeFi
Module 1.3: Understanding Key DeFi Metrics
Module 2.1: Decentralized “Deposits” (Staking)
Module 2.2: Understanding Stablecoins
Module 2.3: Diving into Decentralized Borrowing and Lending
Module 2.4: Dive into Decentralized Exchanges (DEXes) and Swaps
Module 2.5: Decentralized Derivatives
Module 3.1: Providing Liquidity in DeFi
Module 3.2: Yield Farming in DeFi
This course was prepared by Julia Palamarchuk (co-founder of Aqua Protocol — the first CDP stablecoin on the TON blockchain, over-collateralized by liquid staking tokens).
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