Elk Academy Lesson #01: Liquidity Basics
Welcome to Elk Academy! This is the first in a new series of articles designed to give crypto beginners an introduction to the basic concepts behind decentralized finance (DeFi). These short lessons will give you the skills to navigate Elk — along with pretty much any other platform you might want to try. Newcomers to DeFi face a dizzying array of terms, tokens, and acronyms. In these articles, Professor Elkstein will demystify those concepts and show you how DeFi can be both fun and profitable. Remember, you should never invest in something you don’t understand.
Whether your goal is maximizing yields, generating passive income, diversifying your traditional portfolio, or just being part of a global financial revolution, these articles will cover the core concepts so you can invest your money with confidence.
Elk Academy Lesson #1: How to become a Liquidity Provider, for Fun…and Profit!
What is a Liquidity Provision?
A liquidity provision (often abbreviated as LP), is an allocation of assets pooled on a decentralized exchange (DEX) that runs via an automated market maker (AMM) protocol, and which allows for trading of those assets.
Okay, right. But really, what is LP?
In short, LP is the backbone of DeFi and a key part of what makes it “decentralized.” In traditional financial markets, banks and large institutions act as liquidity providers (also called “liquidity provisioners”), supplying a pool of capital to allow for trading on an exchange.
Basically, if you want to create a market for trading apples and bananas, first you need to gather together a lot of apples and bananas so you don’t run out of apples if there happens to be a run on bananas.
In exchange for establishing this pool, liquidity providers typically take a small fee for every transaction, which is how they generate profit. The Great Big Idea of DeFi is that you (or rather, we) become the market maker.
If you provide liquidity on ElkDex, you will earn a 0.3% fee on each trade, proportional to your share of the pool.
People use the shorthand “LP” interchangeably to describe the liquidity provider (the farmer), their liquidity provision (the fruit), or the liquidity pool (the basket) it goes into.
Liquidity refers to the assets generally, but it can also be used to describe how easily one asset can be exchanged for another without causing large price swings in the price of the underlying assets.
Again, think of price as a function of supply and demand: if bananas become scarce, they become more valuable relative to apples. Fewer bananas means the price shift will be more severe each time one is removed.
This shift in price is referred to as slippage, or sometimes price impact (PI). A pool with greater liquidity (i.e. more fruit) can handle more trades with less slippage, so typically the more liquidity in a pool, the better.
On most DEXes, including ElkDex, providing liquidity requires depositing an equal value amount of a pair of two tokens into a pool, which allows other users to swap (i.e. trade) those tokens. When you add liquidity to an existing pool, the AMM will automatically determine the price ratio based on the current value of each token.
What are LP tokens?
When you stake liquidity by depositing your paired tokens, it enters a pool, which is a smart contract that includes the tokens of everyone else who has deposited. LP tokens are essentially a receipt of your deposit, which is used to keep track of how much you are owed when you decide to unstake (remove) your liquidity.
It’s important to keep in mind that LP tokens are placeholders and therefore cannot be traded like regular tokens. Since they are just used for record keeping, exchanges typically do not display or track the value of LP tokens (this would be like asking “What’s the value of an apple and a banana?”).
For this same reason, you may encounter LP tokens with odd looking values, such as 0.00000000567. They are, however, useful for yield farming, which we will tackle in the next lesson.
LP tokens typically carry initials that indicate their source. On ElkDex, for example, all LP tokens are designated ELP, which just stands for Elk LP.
Can I swap two tokens if there is no liquidity available?
Maybe. There needs to be a path to connect two pairs. On ElkDex, all of the liquidity pools use the $ELK token as one of the base pairs (there’s a very important reason for this, which will be explained in a later article!).
But for now, let’s say you want to trade your Apples ($A) for some Bananas ($B). On ElkDex, there will likely be an ELK-A pool and an ELK-B pool. You can therefore swap those two assets using ELK as a go-between, with a path of A>ELK>B.
Sometimes there can be longer paths with three or even four tokens depending on what pairs are available on the DEX. Both ElkDex and ElkNet (which handles cross-chain swaps) are optimized with a smart router, which finds the most efficient path between the two tokens in order to minimize the amount of slippage.
Can I create LP pools by pairing any two tokens?
Yes, you can! But remember, you only earn fees on trades, so if no one is interested in trading your pair, you won’t earn anything. Pairs with higher trade volume generate more fees. If you do decide to create a new pool, it will also be up to you to set the initial price ratio between the two tokens.
What are the risks of becoming a liquidity provider?
There is some risk of a bug or vulnerability in the underlying smart contracts that could expose them to hacks or exploits. For this reason, it is always good to see whether the contracts have been audited by a third-party security firm. (The contracts for ElkDex, which are based on Uniswap contracts, have been audited by HashEx).
But aside from an exploit, which is a relatively minor threat if you are using a reputable platform, the primary risk that liquidity providers face is something called impermanent loss (IL), which happens when the price of the two tokens in the pair diverge.
We will unpack this concept in an upcoming lesson, where we’ll also discuss one of Elk’s unique features, lmpermanent Loss Protection (ILP), which gives our liquidity providers insurance against impermanent loss.
Next time, however, we’ll talk about emissions and yield farming. Did you think you were already farming? Not yet. Yield farming lets you put your LP to work in order to earn tokens on top of trading fees. Double dip!