by Bartcheeks
Previously, I wrote about yield farming via single token exposure, which I find to be something much easier for beginners to utilize. In this newsletter, we’ll be talking about yield farming with multiple tokens, and with multiple tokens we’ll first have to understand the 2 most dreaded words for yield farmers.
Impermanent Loss
Ah, every yield farmer’s greatest worry. Here’s an article by Binance explaining IL perfectly. But a simpler explanation would be this. “Would I have made more money holding the tokens separately?”
In order to not blow up your smooth brain (and mine), I always work under the assumption that every volatile token pair WILL result in IL. Anyone who says so otherwise should be blocked and sent poor quality Hentai.
This is simply due to one reason, that no two volatile tokens will move in exactly the same percentages and direction.
For example, we’ll pair token A and B together and put in the following scenarios, along with this IL calculator for you to try out accordingly.
Scenario 1)
Both price rises.
IL = You are better off holding them separately as the difference in gains for both tokens will be averaged out unfavorably. Remember, it is exceedingly rare for 2 different tokens to move in exact percentages. Any that does consistently will most likely be LP-ed to death with abysmal APR.
Scenario 2)
A stays and B rises.
IL = You are better off holding them separately as your B gains are diluted by A.
Scenario 3)
If A stays and B drops.
IL = You are better off holding them separately as your A value is dragged down by B.
So, in all 3 scenarios, IL-sama will always obliterate you. There is no escape. However, scenario 3 has it’s use as a hedge, which I’ll explain further in the next section.
Benefits of multi-tokens LP
There are 3 reasons why you would want to put your uncorrelated assets into an LP pair.
Fees
Liquidity mining rewards
Hedging
Dollar Cost Averaging into an Index pool
Fees
Fees are basically the tiny percentages that DEXes collects from swaps that goes through their sites. Every time you swap a token from one to the other, a very tiny percentage is kept and usually distribute to the protocol and also to the LP holders. These are your swap fees and are usually put in your LP itself so you’ll see its value grow, resulting in more tokens when you break it back into the underlying tokens.
Liquidity mining
Many DEXes will provide an incentive for you to deposit your LP at their sites. I’ve talked about liquidity mining in Part 4A. Essentially you’re getting bonus tokens from the protocol itself as a reward for improving their liquidity, regardless of the amount of volume being swapped. Most of the time, these bonus rewards for LP pairs are usually higher than just providing a single-sided token, which is fair for being exposed to IL.
LP as a hedge
LPs can be used as a way to hedge a volatile token. In the case of scenario 3 above, the stability of A was used to hedge the drop in B’s price. While scenario 3 used two volatile tokens as an example, ideally a hedged LP would be pairing a volatile token with a stable one, eg USDC-ETH.
I usually do this when I want to continue having an exposure to a volatile token in a downtrend and hedge it while still being able to collect fees and rewards.
This would work because any loss in price by ETH would be hedged by half as USDC is always equal to a $1. On the other hand, if the price were to rise, your ETH gains would be halved too.
Now that we’ve gotten the technical stuff out of the way, let’s start exploring the various types of LP out there!
Dollar Cost Averaging into an Index pool
This involves putting your funds into an LP with a basket of tokens. You can use this as a way to DCA into your favourite tokens while gaining swap fees and rewards, mainly using weighted pools which I’ll explain further below.
Types of LP models
Uniswap V2: Volatile tokens
Uniswap V2: Liquid staking pairs
The magic of Balancer: Weighted pools
Liquidity as a service
Uniswap V3
Uniswap V2: Volatile tokens
This is your standard LP model that basically entails you depositing 2 tokens in a 50/50 ratio and depositing it into a protocol to provide liquidity.
Very vanilla and it’s the easiest to use. You’ll be exposed to the standard IL risks.
Uniswap V2: Liquid staking pairs
Now this one is slightly different. While it’s still the same as above, where you deposit 2 tokens in a 50/50 ratio, an LP pair that involves liquid staking token usually is considered to have “0" IL.
Yes, “0" IL.
Network tokens like ETH and MATIC that has Proof of Stake mechanism allows you to stake your tokens to help validate and secure the network while getting rewards. The drawback is that your tokens are locked in for that period and not usable anywhere else.
Liquid staking allows you to do that and receive a representation of that staked position, eg ETH -> stETH, Matic -> MaticX, and be able to use it elsewhere in DeFi.
Your liquid staked token will increase in value as it gains validator’s rewards.
However, in order to redeem the shown ratio you will have to go through the un-staking process which will require days or up to 2 weeks depending on the token. That, or you can exit immediately through DEXes at a small loss.
Understanding the above, the lack of IL comes from the fact that
1 Matic = 1 Matic
1 MaticX = it’s underlying Matic amount which is always increasing
Now, assuming you’re able to wait through the un-staking process, and if MaticX.
DEX value < Actual ratio. You’ll just end up with more MaticX in your LP to redeem into the underlying Matic amount, which is good if you’re not rushing to exit.
DEX value > Actual ratio. Arbitrageurs will sell MaticX immediately to Matic as it gives more value than the un-staking process, bringing the value back to parity.
Hence, the concept of “0” IL for liquid staked tokens LP.
However, always be aware of the risk of the validator protocol being exploited and its underlying token, eg Matic, being lost, causing MaticX to be valueless.
The magic of Balancer
Now Balancer and Beethoven has an interesting form of LPing that differs from the standard 50/50 ratio, which are weighted pools.
Weighted pools are simply LP pairs (or even 3 and above) that have different ratios (weights).
An example would be Beethoven’s Fantom of the opera, a 70/30 FTM/USDC pool. The benefit of this is that it allows you to minimize IL against the majority token while still allowing you to benefit from swap fees and rewards.
Or even an index fund like Beethoven’s Battle of the Bands.
It’s a pretty interesting form of LP that I personally prefer over the usual 50/50 ones.
Liquidity as a service
LAAS protocols basically allows you to take LP pairs from the respective DEXes and stake them on the LAAS site instead for extra yields.
One of my favourite LAAS is Liquid Driver, which provides higher yield than possible compared to just staking on the DEX itself.
Notice the 13% apy on Liquid Driver vs 6.81% apr on SpiritSwap.
Uniswap V3
Uniswap V3 model has been something that continues to annoy me to no end. While it’s benefits to LP are that it makes capital more efficient, concentrated and active, as your average yield farmer, it’s something that I don’t really like using.
The issue I find is that depositing the tokens into the LP pair requires calculation before hand as the ratio tends to change. eg even with a stable coin pair that is pegged like USDC-DAI, you may end up having to deposit 100 USDC and 900 DAI to form a $1000 LP.
I’d recommend leaving this to the protocols to use, the gigabrains who are using it to twap in and out, or making use of a protocol like Gamma to manage it for you (although you still have to mess with the depositing part).
Conclusion
Yield farming is a very important tool in DeFi IMO, it’s useful in both the bull and bear market. The biggest hurdle you have to overcome is management of IL, which isn’t easy. But once you’ve mastered the basics, you’ll find that it’s easy to grow your assets faster than leaving it idle or in single staking yields.
Thank you for reading part 4B of my primer series! I hope you’ve found this useful. I’d appreciate if you gave me a shoutout and follow me on twitter too.
As usual, stay safe and keep learning friends!
Thanks for reading and for your comment Chris.