LP, to us boomers, means long play, or 33 rpm vinyl. But in the world of decentralized finance, LP has a completely different meaning: provide liquidity, or provide cryptocurrency liquidity to decentralized exchanges, happy to reward your ultimate generosity with other digital currencies.
Decentralized exchanges (or DEX, as I will call them from now on) are similar to centralized exchanges (Binance, Coinbase, Young Platform in Italy, etc.) but compared to the latter they do not have a real headquarters and company: they are located directly on the chain. They are in all intents and purposes a program and nothing more. Most important of all is Uniswap, which recently processes over $1 billion worth of cryptocurrency transactions per day.
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DEXs run exclusively on the blockchain, and they cannot, even if they wanted to, exchange your euros for cryptocurrency. So there is precisely the mainframe. Thus, in DEXs, every transaction is for all intents and purposes a swap, an exchange between two digital currencies, say between Bitcoin and Ethereum or between one of them and a stablecoin.
Why do people increasingly prefer DEXs? Basically, because it works on chain only it is very safe and then because it generally offers very good trading values. These values can also be attractive because the fees they apply to each transaction are very low: Uniswap, for example, applies 0.30%. They can afford it because they don’t have hundreds or thousands of mouths to feed: they are software.
Now, like centralized exchanges and stock markets, DEXs also need liquidity to function, i.e. to bring together supply and demand: if I want to sell a certain cryptocurrency (or share, on exchanges) and you want to buy it, either we meet in the same milliseconds on the value of joint, or the transaction does not occur. For this reason, the provision of liquidity is such an important factor in the markets, that there is a real professional figure, called the market maker, who has always carried out this task: the real companies that provide huge amounts of liquidity to the exchanges in the exchange of interest (the same, to some extent, for central exchanges).
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But with the advent of DEXs, everything has changed and the market maker number has been democratized: today everyone can be one, give their cryptocurrency to DEX and receive a certain fee in return, always in cryptocurrency. But it’s not that simple.
Meanwhile, since each transaction is a swap between two digital assets, it is necessary to participate in dual liquidity pools, i.e. consisting of two cryptocurrencies. Imagine them as a basket where there are, for example, Bitcoin and Ethereum. If I want to buy the former by paying with the latter, the software will deposit my Ethereum into that basket, and withdraw the Bitcoins. Thus, the amount of cryptocurrency is in flux: the more bitcoins bought by payment in Ethereum, the fewer bitcoins and the more Ethereum in the basket.
In order to “get into the basket”, the two digital currencies that make up it are deposited and an LP token is obtained, i.e. a liquidity saving token, what is its price? A combination of the prices of two underlying assets. For example, the price of the ETH-BTC token LP e? A combination of Ethereum and Bitcoin prices. If Ethereum offers +10% and Bitcoin offers +5%, is this possible? Wait for the price to change? of between 5 and 10%. It would be closer to 5% if the “basket” contained more Bitcoin at that moment, or 10% if there was more Ethereum in the basket at that moment, but still to ensure diversified exposure to both assets.
As soon as they enter the pool, our cryptocurrencies immediately begin to “work”, receiving in return their share of the fee (eg 0.30% from Uniswap) that DEX receives from those who use it. It is therefore a very sustainable and transparent fee that is not undermined by questionable marketing (exorbitantly high fees to attract customers).
To provide liquidity to the DEXs, therefore, you have to already own the cryptocurrencies, so you have to send them to an on-chain wallet like Metamask and from there buy LP tokens for a pool of DEX. We also need to specify the price range of the two cryptocurrencies for which we want the program to use our liquidity for compensation, for example Bitcoin between 18 and 23 thousand euros, or between 5 and 50 thousand: the smaller the range and the higher the compensation, the lower the probability of using our liquidity . You have to be very expert to select the optimal range.
Finally, you should pay attention to the so-called “non-permanent loss”, or momentary loss. Since transactions in DEXs are, as mentioned, an exchange (Swap) between one cryptocurrency and another, the pools are binary. Let’s imagine them as baskets of apples and pears. A customer who wants to sell pears arrives to buy apples: does the DEX smart contract deposit and withdraw the pears that the customer wants to sell? The apple the customer wants. In fact, if there is more demand for apples in the market, there will be fewer in the basket (people tend to sell pears to buy apples). Whether anyone entered the liquidity provision mechanism? With a mixture of apples and pears, at certain times you may find yourself with fewer apples (or pears) than when and? I entered (because everyone wants them and a lot of the basket was taken). This is the impermanent loss, or rather a temporary loss: it suffices that there be demand again the next day for the pears bought by selling the apples and to rebalance everything.
In general, providing liquidity to DEXs may be the best way to increase cryptocurrency stocks on a daily basis today, but it is certainly not the easiest. Because of this, it will remain an expert mode for a long time to come. However, at Anubi Digital we recently introduced a new service, coincidentally called DUO (yes, we didn’t have much imagination), which tries to make a rather complicated process simple, as we have seen. It will be interesting to observe if and how it will be received by the market.