Decentralized finance (DeFi) is a financial ecosystem that is built on a blockchain network such as Ethereum. DeFi is open-source and is transparent without control from a centralized authority. It eliminates the need for intermediaries in transactions and the accompanying fees and congestion that they bring.
A core perk of DeFi is the ease with which users can access financial services. Users also maintain complete control over their assets. They can interact directly with other users by using smart contracts as neutral third parties. These smart contracts can facilitate a large number of financial interactions such as borrowing, lending, and automated market making.
DeFi ecosystems are one of the largest and fastest-growing niches in crypto. The sector has a market cap of US$121B at the time of writing.
What Are Liquidity Pools?
For any financial service to run smoothly, there has to be sufficient liquidity. The ease with which traders can exchange cryptocurrency for other cryptocurrencies or fiat is known as ‘liquidity’. Each decentralized protocol pools funds together inside a ‘vault’, these vaults are known as liquidity pools. A liquidity pool can contain stablecoins and non-stable assets.
Services such as lending, token swapping, and borrowing are executed via smart contracts. A liquidity pool (LP) is one of such contracts where users of a protocol earn rewards by locking their assets. Other users pay fees to utilize the liquidity inside these pools for trades.
Liquidity pools are the foundation of DeFi applications and are used in loan dApps, yield farms, automated market makers (AMMs), and even for gaming.
To provide tokens to an LP, you will have to deposit an equal dollar amount of the tokens into the smart contract. To add liquidity to an ETH/DAI pool on Uniswap, equal amounts of ETH and DAI are needed, meaning if you put in $100 worth of DAI, you also need to put in $100 worth of ETH.
LPs require equal amounts of tokens because trades on decentralized exchanges are two-sided. Allowing liquidity providers to deposit only one token would lead to a deficit in one of the assets in the pool.
Liquidity providers are rewarded with more of the tokens they staked or the native token of the protocol. For example, protocols like Compound reward liquidity providers with the COMP LP token.
What is Impermanent Loss?
The rewards that come with earning passive income in DeFi protocols do not come without risks. For liquidity providers, impermanent loss is one of them. Impermanent loss happens when there is a change in the price of the assets you locked in a liquidity pool. The larger the price change, the bigger the size of the impermanent loss. This could mean a steep depreciation in the size of your capital for the short term.
If you deposit 1 ETH and 1000 DAI into a liquidity pool, a change in the price of ETH will alter the value of your deposit. If 1 ETH is equal to 1000 DAI, it then means that if there are 10 ETH in a pool, there should also be 10,000 DAI.
By providing 1ETH and 1000 DAI, you are eligible for 10% of the transaction fees on the protocol (usually 0.3% per trade). If the price of ETH appreciates by 100% (2000 DAI per ETH), the protocol rebalances your deposit ratio leading to an impermanent loss of 50% of capital. This means if you were to withdraw your tokens from the pool, you would receive 0.75 ETH and 1500 DAI. If your goal is to end up with more ETH, then you would have been better off just holding the ETH, rather than depositing it into a liquidity pool.
Keep in mind, the loss is only permanent if you withdraw your capital. The rewards from LPs sometimes make up for temporary losses incurred from price fluctuation.
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