Liquidity Pools and Yield Farming — VegaX Research Report
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Liquidity Pools and Yield Farming
An attractive aspect of the decentralized finance (DeFi) space is the abundance of options that investors have when making decisions. The plethora of choices comes with trade-offs — but, enabling users to make decisions based on their particular goals and risk models is an empowering facet that embodies the sentiment of the free market.
Participants in digital asset markets have likely come across the terms “liquidity pool” and “yield farming,” as these are buzzy phrases in today’s DeFi lexicon. What exactly do they mean, and why does it seem like every project and protocol mentions them?
The following piece will:
- Outline differences between centralized and decentralized exchanges “CEX v DEX”.
- Define liquidity pools, and describe how DEX protocols utilize them.
- Review yield farming as a concept.
- Discuss risks and additional considerations associated with these strategies.
Centralized Exchanges (CEX)
A centralized digital asset exchange functions in essentially the same way that a traditional securities broker would: the exchange acts as an intermediary, facilitating transactions between counterparties and keeping extensive records of all transactions.
Additionally, as each order is validated, it is passed through a centralized security process, and ultimately maintained on the exchanges’ internal server system. Generally, CEXs are subject to the regulatory requirements of their respective jurisdictions — as well, most firms have rigorous know-your-customer and anti-money-laundering (KYC/AML) policies meant to deter any theft or manipulation of client accounts and/or funds.
Newer participants in the digital asset market tend to opt for centralized exchanges for their ease of use, clean interfaces, high-speed transaction settlements, and the variety of assets/pairings available. Plus, centralized exchanges typically provide the option to purchase digital assets against fiat currency, a feature not found on most DEXs.
Due in part to the wide variety of trading pairs, fixed trading fees, and asset prices near or at spot value, CEXs typically experience a larger volume of transactions than DEXs.
Decentralized Exchanges (DEX) and Liquidity Pools
DEXs are built upon blockchain technology, as such, they leverage the distributed nature of blockchains: there is no singular location in which a protocol’s servers “live” — DEXs utilize various cloud services to host their data.
In addition, the only participation barriers to entry are that a user has 1) a device with an internet connection and 2) a wallet set up for the particular blockchain upon which they are transacting; no sensitive personal information is required to trade.
Similar to CEXs, a decentralized digital asset exchange offers to order books, matching systems, security functions, and a trading venue (via a website-based interface). While they offer similar services, the implementation of the back-end processes that facilitate trading differ.
How are traders matched on a DEX?
Many DEX protocols operate an “Automated Market Maker” (AMM) algorithm that automatically matches buyers with sellers of a particular asset.
The algorithm references levels of liquidity, concerning the asset(s) to be swapped, within the protocol’s liquidity pools. Essentially, a liquidity pool is a collection of one or more assets “pooled” together in a specified ratio (i.e. 50% asset A, 50% asset B), acting as a source of liquidity to facilitate trades and swap transactions that take place on the exchange.
Liquidity Pool Functionality
In order to maintain liquidity levels within the pools, DEXs incentivize users to become liquidity “providers” by offering yield on their deposits, expressed as APR/APY (depending on the protocol). As an example, let’s review the ATOM (Cosmos Hub token) / CRO (Crypto.com token) pool on the Osmosis DEX:
The bracketed portion of the image above represents three different options for liquidity providers, based on the number of days they are willing to let their assets “unbond” — sit idle, not accruing rewards — before they are able to withdraw their assets. Osmosis offers unbonding periods of 1, 7, and 14 days, where the longer the unbond period, the higher the yield offered on deposits.
It should be noted, however, that these yield figures are anything but static: DEXs will sometimes advertise seemingly impossible yields (> 1000% APR) as a marketing tool to entice users onto their platforms. If enough users decide to deposit funds, those gaudy yields eventually deflate to sustainable levels; and from there, yields are more closely associated with the relative level of liquidity within the pools.
Along with Came Farmers…
Market participants in the DeFi space have come to understand this phenomenon, as such, certain users will enact an investment strategy called “Yield Farming,” wherein farmers will provide assets to specific DEX protocols offering high yields. This strategy has changed the way that investors earn passive income: by rotating the protocols (and assets) that they “farm,” some investors are able to make substantial returns.
Importantly, yield farming is by no means an “easy” way to earn passive income — in fact, successful yield farmers spend hours doing their due diligence on tokens, protocols, Dev teams, smart contract platforms, and the communities built around the protocol to find the optimal balance between security and yield.
In short: if one’s aim is to outperform the broader market, DeFi yield farming is a full-time job. Consider that, because digital asset markets never close (tradable 24/7/365), farmers need to find solutions for risk indicators and alerts, otherwise, they risk missing a potentially catastrophic move in their portfolios while they sleep.
Risks and Considerations
Impermanent Loss
An investor ought to be familiar with the concept of “Impermanent Loss” before supplying assets to a liquidity pool (or yield farming). Recall, in the above overview of liquidity pools, that assets are supplied in predetermined ratios — if the value of one asset declines relative to another, the pool is algorithmically rebalanced to maintain the ratio.
Take the above example of the ATOM/CRO pool on Osmosis, the assets are supplied in a ratio of 50/50, but notice that the TOTAL AMOUNTS of each asset are different. This is due to the price difference between them. As a hypothetical scenario:
ATOM drops in price from $10 to $5, in this case, a portion of CRO would be sold, to buy ATOM in order to maintain the 50/50 ratio. Liquidity providers in this pool would then be operating at a loss, as some of their CRO has been sold to cover the detrimental price action in ATOM.
While this can be an intimidating (and confusing) facet of participating in liquidity pools, the impermanent loss is only actualized at the point of withdrawal, and several DEX protocols offer usersimpermanent loss downside protection at little or no cost to the user.
Final Considerations
When participating in a liquidity pool (or beginning a yield farming operation), take the time to conduct a full due diligence review. In addition to impermanent loss, consider the unbonding/withdrawal lock-up period — each investor’s appetite for risk/return ratio is different.
Further, investors ought to be diligent in the ecosystems, protocols and dApps they choose to trust, as there exist no guarantees of solvency in the DeFi space.
The decentralization implied in a DEX protocol does necessitate that users have custody of their own assets meaning they manage their digital asset wallets, as opposed to trusting an exchange to do so.
This poses risks to users: first, they must develop a minimum technical capacity to securely hold private keys and maintain their own digital asset wallet(s). Second, this self-custody exposes users to would-be hackers and cybercriminals, effectively putting a target “on their backs.”
Within the DeFi ecosystem, several managed custody-oriented firms currently operate and provide users with vaults and other security solutions for users. At VegaX, we are actively developing an index-based investment product that tracks the five largest DEX assets, providing investors a secure way to gain exposure to the sector — we hope to release it very shortly!
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