4. The Good, the Bad and the Ugly of being an LP

All exchanges need liquidity to facilitate trade. More liquidity leads to lower slippage and better execution price. Liquidity providers (LPs) provide liquidity to exchanges in return for some rewards. This article covers the good, the bad and the ugly of being an LP on an AMM style DEX (e.g. Phezzan, Uniswap).

The Good

Most DEXs reward a portion of trading fees to LPs. For example, Uniswap rewards 100% of trading fees to LPs. Phezzan testnet currently rewards 70% of trading fees to LPs. If there are a lot of trading volume on a DEX, LPs can earn a lot of trading fees.

Uniswap’s ETH-USDC pool collected $217.78M fees over the past 14 months. These fees all go to LPs.

Traditionally, only professional market makers can provide liquidity to exchanges. AMM style DEXs allow anyone to provide liquidity. To attract more liquidity, most AMM style DEXs reward LPs with token via liquidity mining programs. The reward typically has 20% — 300% APR, and LPs usually receive rewards in the form of native token of the DEX.

So being an LP sounds great with trading fees and liquidity mining rewards, right? Not so fast.

The Bad

Most LPs in AMM style DEXs are losing money. Bancor analyzed 17 pools on Uniswap V3, covering 43% of Uniswap’s TVL (https://arxiv.org/pdf/2111.09192.pdf). LPs in only 3 out of those 17 analyzed pools have positive earnings.

Most AMM style DEXs solve this problem by subsidizing LPs through liquidity mining programs. However this strategy is not sustainable in the long run. DEXs can’t pay for LPs’ losses forever. To make the situation worse, LPs might be losing money so much that even liquidity mining rewards won’t cover LPs’ losses. Perpetual Protocol V2 (Perp V2), an AMM style perpetual DEX, can’t attract enough LPs (who wants to lose money?) so their team has to be an LP themselves.

Needless to say, Perpetual Protocol’s team is losing money as an LP.

So why are LPs in AMM style DEXs losing money?

The Ugly

LPs in AMM style DEXs suffer impermanent loss (IL) when providing liquidity. Impermanent loss is the difference between putting assets into an AMM style DEX as an LP and holding the same assets. In short, an LP will suffer an impermanent loss as long as the price is different between the LP deposits and withdraws liquidity from an AMM style DEX.

LPs in AMMs are the counterparty to traders. In the Uniswap ETH-USDC pool, LPs start with equal dollar value of ETH and USDC. If the price of ETH goes up, that means traders are buying ETH, thus LPs’ ETH are sold for USDC. LP would have been better off by holding ETH and USDC (because LP sells ETH when ETH price goes up). If the price of ETH goes down, that means traders are selling ETH, thus LPs are forced to sell USDC to buy ETH. Again LPs would have been better off by holding ETH and USDC (because LPs buy ETH when ETH price goes down). The only scenario where LPs won’t be worse off than not LPing is if the price of ETH comes back to LPs’ entry price.

If the price of ETH goes up in the Phezzan ETH-USDC pool, that means traders go long. Thus LPs will have a short position and then lose money because the price of ETH is up but LPs have a short position on ETH. This works both ways so the only scenario where an LP doesn’t lose money is when the price of ETH comes back to an LP’s entry price, which rarely happens.

For most Uniswap pools, LP fees earned are less than impermanent loss occurred during a certain time frame. LPs are effectively losing money. This happens even though Uniswap V3 gives 100% of trading fees to LPs.

Impermanent loss exists primarily because LPs in AMMs are forced to make bad trades. AMM algorithm makes LPs trade against price movements, so no matter if the price of an asset goes up or down, LPs lose.

Besides impermanent loss, capital inefficiency of AMM is a nightmare for LPs as well. dYdX (orderbook) and Perp V2 (AMM) have roughly the same TVL in some pools, but dYdX has only 1/10 of Perp V2’s slippage for the same trade. dYdX only needs 1/10 of Perp V2’s liquidity in the same pool for the same trading experience. Trading fees received as an LP roughly equals to dollar invested / TVL * volume. For the same $1 invested as an LP, ceteris paribus, orderbook DEXs will return 10 times more trading fees than AMM style DEXs.

A Silver Lining

So how can LPs earn money?

1) By LPing at DEXs that give enough trading fees and liquidity mining reward. Phezzan V1 might belong to this camp. The party can’t last forever, but enjoy it while it still lasts.

2) By hedging the position with options. For example, straddle (https://www.investopedia.com/terms/s/straddle.asp) allows users to earn money with price movements. LPs’ earning from straddle can offset impermanent loss. But LPs need to pay for a premium and straddle can only cover a certain percentage of price movements. LPs probably need to be an expert in trading to go this route.

3) LPing at an orderbook style DEX. Phezzan V2 will be a pure orderbook style DEX while allowing everyone to be an LP. Phezzan Protocol will partner with professional market makers and startups to create automatic strategies, where users can choose different market making bot strategies with a click of mouse. Think of it as adding liquidity in a Uniswap liquidity pool, only this time there will be no impermanent loss. For more details, take a look at Our Vision for Phezzan Protocol Mainnet V2.

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