On Liquidity Pools, AMMs, Yield Farming, etc.

[brianwalden]

First, let me say, I'm by no means an expert, I'm just sharing my experiences.

I think liquidity pools have been revolutionary for crypto. They've been the driving force behind the rise of DeFi. Not everyone can be a day trader (I certainly can't) - it takes a certain kind of mind and a set of brass balls. The rest of us would basically buy long, hodl, and hope. Liquidity pools have brought all that capital that was just sitting there waiting for the moon into the market. With liquidity pools you don't have to know how to do TA or time the market - you just put your funds into the pool and farm the fees that people pay as they trade between the two coins. These pools also bring liquidity to obscure currency pairs that traders don't want to trade.

But I think on the whole I'm not real big on them. They're not the set it and forget it system that a lot of people imagine them to be. First, a lot of people think of them as a safe way to just farm trading fees - the high APYs that are published seem to cover the volatility in the market. I don't know that this is necessarily the case. If, for example, a pool has a quite high 365% APY, that means you'll earn 1% per day (technically slightly less but this is not the place to discuss APR vs APY). But cryptos typically move way more than 1% per day. The entire crypto world is volatile, few people are going to take a position in a pool and hold it for a year. If you're only in the pool for a week, you'll make 7% if the rate holds, but it wouldn't be unusual for the value of one of your cryptos in the pool to drop more than 7% in a single day.

Impermanent loss. You can google the details, but basically the way the math of liquidity pools work, whenever the two coins move relative to each other (i.e. the exchange rate between them changes), if you're in the pool you lose money compared to if you had just held the two coins separately. The goal is that the fees the pool gathers from people trading between the two sides will offset this loss and then some. You can also mitigate it by timing when you enter and exit the pool so that the rate is about the same for each. I had studied up on impermanent loss, but that didn't prepare me for actually experience. It sucks when you're in a crypto-USD pool and the crypto is going down bringing the overall value of the pool (and thus your position it it down) and on top of that the pool keeps shifting more dollars into your crypto that's dumping, adding impermanent loss on top of your regular losses. Thankfully I haven't the experience of being in the same type of pool when the crypto goes to the moon only to find out that the pool keeps selling it for more dollars as it soars up in price. I don't know what I'd do if that happened to me.

The rate they give you vs. the rate you make. No one really talks about this, but fees are everywhere and they're very hard to keep track of. It's not just the network transaction fees, many pools have additional fees built into them when you enter and/or exit the pool, when you claim rewards, etc. The fees come out after the APY that they publish gets calculated, meaning you're never going to actually make that APY. Many pools will pay you rewards in their own governance token. Those rewards count as a part the APY being paid out by the pool. Whatever you do with that token there are fees to claim it, stake it, put it in it's own pool, or sell it. If its price goes down while you're still holding it, so do your earnings. Personally, I'm not big on governance tokens unless they've got some real utility to support their price.

Here's what I think my biggest gripe is. Liquidity pools are mathematically constructed to allow the pool to keep going no matter what happens - pump or dump, gaining liquidity or losing it. This is important, and it's a good thing; whatever people do the pool it just adjusts and keeps going so it's always there to trade against. But it's not necessarily what's best for your money. If one of your coins is mooning, it's best for you for the pool to just stop and hold it (and maybe even buy more). But that's not what the pool will do.

While I think liquidity pools are an important development, there's a reason why real traders use order books where they have precise control over what price they want to buy and sell at. If you're going to provide liquidity to a pool, you can't just look at the APY and jump in. Try to look at the full picture: the volatility between the two coins, the fees involved, how you're paid the yield you earn, the size of the pool, and the transaction volume. I'm not a fan of the very common strategy of farming a volatile crypto against a stablecoin, but here are three strategies that I like.

The Day Farmer - I don't know if that's a thing, but if not, I just coined it. This is also called going full DeFi degen(erate). You're basically the farming version of a day trader. You'll be chasing those huge APYs, getting in while the rewards are big and then getting out quickly before they dry up. Make hay while the sun is shining. This takes constant attention to your positions and a lot of intestinal fortitude. It's a good option for a day trader who's looking to expand his opportunities, but I don't think it really fits the typical person who's just looking to get some yield on his investment.

The Stable Farmer - This is for the person who's just looking for yields, you farm two stablecoins like USDT/USDC so you can just earn yield without having to worry about impermanent loss. Curve Finance has become one of the biggest DeFi apps based on this model. You're almost treating this like a savings account, slowly and steadily gaining interest over time.

The Long Farmer - If you're long on a coin and you can farm a derivative of it, or at least something that moves similar to it to reduce impermanent loss, you can still reap (nearly) all the gains while it pumps, but also earn some yield on top of that. For example right now I'm farming a coin and a token representing its staked version of itself. The price difference between them basically represents how badly people want to trade their staked one for the real thing instead of waiting three weeks to unstake it. That price will fluxuate as demand changes, but it shouldn't move by too much. I think this can work to varying degrees even with two different coins, I haven't looked into this but I suspect BNB and CAKE (the biggest DeFi app on BSC) might kind of move similarly to each other. Maybe XRP and XLM move pretty close to each other, I know they certainly seem to do so sometimes. Any two coins that kind of follow each other could work. I never knew what, "Long your longs," meant, but this is how I conceive of doing it.

Where do I think the future of liquidity pools is going? I think back to the original automatic market makers: trading bots. Only this time they'll be decentralized smart contracts. These will give people a few options to select which strategies they want to use for trading. As  they evolve, they'll get more complex while also hiding that complexity from the user. Maybe an arbitrage bot, for example would be looking at several markets waiting for an arbitrage loop to appear and then hit it hard when it does. The code behind this would be much more complicated than the elegant equation underlying liquidity pools, but to the user all they would have to do is deposit their funds and the bot would go to work with them. This system can evolve until you basically get various mutual funds only without the fund manager - just a smart contract reading the markets and following its instructions.

[BillyOckham]

7 hours ago, brianwalden said:

First, let me say, I'm by no means an expert, I'm just sharing my experiences.

I think liquidity pools have been revolutionary for crypto. They've been the driving force behind the rise of DeFi. Not everyone can be a day trader (I certainly can't) - it takes a certain kind of mind and a set of brass balls. The rest of us would basically buy long, hodl, and hope. Liquidity pools have brought all that capital that was just sitting there waiting for the moon into the market. With liquidity pools you don't have to know how to do TA or time the market - you just put your funds into the pool and farm the fees that people pay as they trade between the two coins. These pools also bring liquidity to obscure currency pairs that traders don't want to trade.

But I think on the whole I'm not real big on them. They're not the set it and forget it system that a lot of people imagine them to be. First, a lot of people think of them as a safe way to just farm trading fees - the high APYs that are published seem to cover the volatility in the market. I don't know that this is necessarily the case. If, for example, a pool has a quite high 365% APY, that means you'll earn 1% per day (technically slightly less but this is not the place to discuss APR vs APY). But cryptos typically move way more than 1% per day. The entire crypto world is volatile, few people are going to take a position in a pool and hold it for a year. If you're only in the pool for a week, you'll make 7% if the rate holds, but it wouldn't be unusual for the value of one of your cryptos in the pool to drop more than 7% in a single day.

Impermanent loss. You can google the details, but basically the way the math of liquidity pools work, whenever the two coins move relative to each other (i.e. the exchange rate between them changes), if you're in the pool you lose money compared to if you had just held the two coins separately. The goal is that the fees the pool gathers from people trading between the two sides will offset this loss and then some. You can also mitigate it by timing when you enter and exit the pool so that the rate is about the same for each. I had studied up on impermanent loss, but that didn't prepare me for actually experience. It sucks when you're in a crypto-USD pool and the crypto is going down bringing the overall value of the pool (and thus your position it it down) and on top of that the pool keeps shifting more dollars into your crypto that's dumping, adding impermanent loss on top of your regular losses. Thankfully I haven't the experience of being in the same type of pool when the crypto goes to the moon only to find out that the pool keeps selling it for more dollars as it soars up in price. I don't know what I'd do if that happened to me.

The rate they give you vs. the rate you make. No one really talks about this, but fees are everywhere and they're very hard to keep track of. It's not just the network transaction fees, many pools have additional fees built into them when you enter and/or exit the pool, when you claim rewards, etc. The fees come out after the APY that they publish gets calculated, meaning you're never going to actually make that APY. Many pools will pay you rewards in their own governance token. Those rewards count as a part the APY being paid out by the pool. Whatever you do with that token there are fees to claim it, stake it, put it in it's own pool, or sell it. If its price goes down while you're still holding it, so do your earnings. Personally, I'm not big on governance tokens unless they've got some real utility to support their price.

Here's what I think my biggest gripe is. Liquidity pools are mathematically constructed to allow the pool to keep going no matter what happens - pump or dump, gaining liquidity or losing it. This is important, and it's a good thing; whatever people do the pool it just adjusts and keeps going so it's always there to trade against. But it's not necessarily what's best for your money. If one of your coins is mooning, it's best for you for the pool to just stop and hold it (and maybe even buy more). But that's not what the pool will do.

While I think liquidity pools are an important development, there's a reason why real traders use order books where they have precise control over what price they want to buy and sell at. If you're going to provide liquidity to a pool, you can't just look at the APY and jump in. Try to look at the full picture: the volatility between the two coins, the fees involved, how you're paid the yield you earn, the size of the pool, and the transaction volume. I'm not a fan of the very common strategy of farming a volatile crypto against a stablecoin, but here are three strategies that I like.

The Day Farmer - I don't know if that's a thing, but if not, I just coined it. This is also called going full DeFi degen(erate). You're basically the farming version of a day trader. You'll be chasing those huge APYs, getting in while the rewards are big and then getting out quickly before they dry up. Make hay while the sun is shining. This takes constant attention to your positions and a lot of intestinal fortitude. It's a good option for a day trader who's looking to expand his opportunities, but I don't think it really fits the typical person who's just looking to get some yield on his investment.

The Stable Farmer - This is for the person who's just looking for yields, you farm two stablecoins like USDT/USDC so you can just earn yield without having to worry about impermanent loss. Curve Finance has become one of the biggest DeFi apps based on this model. You're almost treating this like a savings account, slowly and steadily gaining interest over time.

The Long Farmer - If you're long on a coin and you can farm a derivative of it, or at least something that moves similar to it to reduce impermanent loss, you can still reap (nearly) all the gains while it pumps, but also earn some yield on top of that. For example right now I'm farming a coin and a token representing its staked version of itself. The price difference between them basically represents how badly people want to trade their staked one for the real thing instead of waiting three weeks to unstake it. That price will fluxuate as demand changes, but it shouldn't move by too much. I think this can work to varying degrees even with two different coins, I haven't looked into this but I suspect BNB and CAKE (the biggest DeFi app on BSC) might kind of move similarly to each other. Maybe XRP and XLM move pretty close to each other, I know they certainly seem to do so sometimes. Any two coins that kind of follow each other could work. I never knew what, "Long your longs," meant, but this is how I conceive of doing it.

Where do I think the future of liquidity pools is going? I think back to the original automatic market makers: trading bots. Only this time they'll be decentralized smart contracts. These will give people a few options to select which strategies they want to use for trading. As  they evolve, they'll get more complex while also hiding that complexity from the user. Maybe an arbitrage bot, for example would be looking at several markets waiting for an arbitrage loop to appear and then hit it hard when it does. The code behind this would be much more complicated than the elegant equation underlying liquidity pools, but to the user all they would have to do is deposit their funds and the bot would go to work with them. This system can evolve until you basically get various mutual funds only without the fund manager - just a smart contract reading the markets and following its instructions.

Thanks for this extraordinary post.  Everything I needed to know but didn’t know I did.  Explained in terms that even I can understand.

Sincere thanks for explaining all that.

 

Well done Brain,  you have made your mum and I proud.   

[brianwalden]

18 minutes ago, BillyOckham said:

Thanks for this extraordinary post.  Everything I needed to know but didn’t know I did.  Explained in terms that even I can understand.

Sincere thanks for explaining all that.

 

Well done Brain,  you have made your mum and I proud.   

Thanks Dad. You're never too old to farm.

[BillyOckham]

6 minutes ago, brianwalden said:

Thanks Dad. You're never too old to farm.

Just to set the record straight for those that don’t know….  I was joking and so was Brian.  We don’t know each other.

I truly do think his post was excellent.

[brianwalden]

6 minutes ago, BillyOckham said:

Just to set the record straight for those that don’t know….  I was joking and so was Brian.  We don’t know each other.

I truly do think his post was excellent.

Oh Dad, you're such a trickster. I don't know you either.

Edited August 4, 2021 by brianwalden
*wink*

[NightJanitor]

Well, well... excellent farming analogies... and I just brought out my toy John Deere to clean up for a kiddo.

Next thing you know, the Agriculture Committee will wake up and smell the bullshit emanating from SEC! :)