50% of Liquidity Providers Lose Money: Here is How To Avoid That - Chain Debrief (2024)

FAQs

How do liquidity providers lose money? ›

Impermanent Loss occurs when liquidity providers deposit assets into a liquidity pool and the prices of the tokens within that pool change. The larger the price fluctuations compared to when the assets were initially deposited, the greater the loss for the LP.

Impermanent Loss: Impermanent loss occurs when the price of the assets in the liquidity pool changes relative to the price outside of the pool. Liquidity providers can experience financial losses when withdrawing their assets.

Essentially, as the relative prices of assets in a pool change, a liquidity provider might end up with less value than if they had simply held onto the tokens outside the pool. Over time, if the token prices revert, this loss can be mitigated, hence the term 'impermanent.

In the equities space, many stock exchanges rely on liquidity providers who make the commitment to provide liquidity in a given equity. These liquidity providers commit to providing liquidity in the hopes that they will be able to make a profit on the bid-ask spread.

Liquidity provider fees​

There is a 0.3% fee for swapping tokens. This fee is split by liquidity providers proportional to their contribution to liquidity reserves. Swapping fees are immediately deposited into liquidity reserves.

What Is a Liquidity Crisis? A liquidity crisis is a financial situation characterized by a lack of cash or easily-convertible-to-cash assets on hand across many businesses or financial institutions simultaneously.

For banks, liquidity risk arises naturally from certain aspects of their day-to-day operations. For example, banks tend to fund long-term loans (like mortgages) with short-term liabilities (like deposits). This maturity mismatch creates liquidity risk if depositors withdraw funds suddenly.

Liquidity providers perform important functions in the market such as encouraging price stability, limiting volatility, reducing spreads, and making trading more cost-effective. Banks, financial institutions, and trading firms are key players in providing liquidity to different parts of the financial markets.

Liquidity generally refers to how easily or quickly a security can be bought or sold in a secondary market. Liquid investments can be sold readily and without paying a hefty fee to get money when it is needed.

How to profit from liquidity? ›

Choosing a Liquidity Pool for liquidity provision

Higher trading volume boosts profits for liquidity providers, but pools with lower TVL and higher trading volume are usually more profitable. In simple terms, look for pools with high trading volume and low TVL for better long-term profits.

LPs are crucial in financial institutions, impacting transaction efficiency, pricing, and trade execution. Key criteria for identifying the best liquidity providers include regulatory compliance, financial stability, robust technology infrastructure, competitive pricing, diverse instruments, etc.

As you can see, liquidity mining can be rather complex and time consuming, and can expose you to risks, including impermanent loss.

On the Web app: To remove Liquidity from Liquidity Mining, please go to your Liquidity Mining Page, scroll down until you see "My Liquidity", and then you can on the right side of the pool under "Actions", click "Remove".

It is possible to recover from impermanent loss if the ratio of the asset values in the liquidity pools returns to previous levels. However, it's not guaranteed that two uncorrelated assets will return to previous levels after a large change in price.

As you can see, liquidity mining can be rather complex and time consuming, and can expose you to risks, including impermanent loss.

Impermanent Loss: One of the biggest risks associated with becoming a liquidity provider is impermanent loss. It occurs when a token's price change causes a user's share in a liquidity pool to be worth less than the value of their deposit.

At the root of a liquidity crisis are widespread maturity mismatching among banks and other businesses and a resulting lack of cash and other liquid assets when they are needed. Liquidity crises can be triggered by large, negative economic shocks or by normal cyclical changes in the economy.

There are downsides to liquidity. Liquidity can undermine a disciplined investment plan. For example, it can exacerbate emotional investing, both out of fear and out of greed. Financial liquidity can also lead to lower returns as investors miss out on potential liquidity premiums that can come with illiquid assets.