Over the past year, DeFi has grown at a staggering rate. In January of last year, there was about $800M total value locked in DeFi. Today, over $26B of total value is locked, representing a growth rate of over 3500%. Much of that growth is due to the profit potential from staking assets in yield-bearing pools (AKA yield farming). Simply put, liquidity providers supply liquidity to a pool on an AMM (automated market maker) and receive a small fee from each transaction. Liquidity providers receive ‘LP tokens,’ representing their share of the pool, which appreciates from the fees accrued by the AMM. Yield farming can take many forms, but typically yield farmers have the option to ‘stake’ those LP tokens in various protocols for additional rewards.
Providing liquidity to a pool comes with significant risks. The risk level is mostly dependent on how volatile the pool’s assets are and how much total liquidity is provided to the pool. Below we will highlight each of the most significant risks and discuss how users can help mitigate these challenges.
The risks associated with becoming an LP
For volatile assets, the most significant risk comes from the possibility that one or both pooled tokens will decrease in value. Let’s assume that a user provides liquidity at a ratio of 50/50 to the ETH <> WBTC pair. If the price of ETH drops (relative to a stablecoin like USDT) by 30%, that user’s entire position value will decrease by about 16%. If the price of both ETH and WBTC drops by 30%, the entire position’s value will decrease by about 30%. With highly speculative tokens, prices are incredibly volatile, and LP positions generally require constant monitoring to prevent losing a large chunk of value.
Simply put, impermanent loss (IL) occurs when the value of one or both of the underlying tokens in the liquidity pool changes when compared to the price at which the tokens were deposited. This means that if the price of the two assets in the LP do not move perfectly in sync (which can not be expected from two entirely different tokens), a position holder will have IL.
It’s essential to note that impermanent loss isn’t that helpful or important of a metric. By calculating IL, a user is essentially comparing their current pool value to an entirely theoretical one. In other words, it’s like going to one’s money manager and complaining that because the money manager invested in both ETH and BTC and balanced your funds, you made less than strictly holding BTC. It’s more practical to look at the dollar or stablecoin value of one’s LP position. If you still want to calculate IL, you can check out this convenient link.
If the liquidity pool experiences a rapid loss of liquidity, it can be challenging to sell the underlying assets in the pool. This can happen quickly and without warning, especially with volatile tokens. An extreme version of this is called a ‘rug pull.’ A rug pull occurs when the original LP and often token creator “Waits for people to swap their ETH for the newly minted coin, after which the token’s creators would drain the liquidity pool, leaving holders with nothing but a worthless coin.” This is difficult to monitor manually, and by the time the average user notices what happens, their tokens are worthless.
Rapid losses of liquidity can also lead to high slippage. Slippage is when a trader ends up receiving less of the token they’re purchasing due to an increase in that token’s price. This occurs when the trader’s trade is large enough to move the token’s price unfavorably for the trader and is most common in illiquid liquidity pools.
If a yield farmer is lucky, they will be one of the early entrants into a new pool. This means that they will ‘own’ a large portion of the pool and will represent a significant chunk of liquidity. This generally means that they will be receiving high yields. As more users discover the yield farm, the early adopters get diluted and eventually own less and less of the pool. This generally correlates to lower yields. At some point, the yield can become so low that it doesn’t warrant the risk of being an LP. This is something that LP’s should also monitor closely.
Brink will lower your risks as a liquidity provider
To help protect DeFi users from the risks associated with yield farming and address the issues mentioned above, Brink plans to launch liquidity provider protection on pooled assets.
Brink has developed a type of conditional order that can be set by the user to help protect from impermanent loss and general loss associated with being an (LP) liquidity provider. Executors on the Brink network will monitor the following variables in a user’s LP position: (1) the value of the pooled assets, (2) impermanent loss (IL), (3) pool liquidity, and (4) pool share/dilution. These executors can automatically liquidate the position if any of these parameters trigger the user’s predefined, custom threshold.
Brink’s first solution is to offer users the option to set a ‘stop-loss’ on their pool’s value. If the pool value drops below a certain threshold, Brink can automatically liquidate the LP position and convert it to a stablecoin.
Brink users will also be able to set a ‘limit’ on their LP position. If the value of one or both tokens appreciates enough that the LP position’s value increases to a user-defined threshold, the entire position can be sold to lock in profit. This is significantly more practical than manually monitoring one’s LP position. Yield farmers deserve to sleep!
The Brink service can also monitor a pool’s liquidity level, and Brink users can set a liquidity threshold. If the total value locked in a liquidity pool dips below a certain level or falls by a certain percentage, the Brink service can automatically exit a user’s LP position. On the other hand, if TVL in an LP grows too much, the Brink service can monitor what percentage of the pool the user owns and automatically liquidate the position if the user becomes too diluted.
At Brink, we are building critical infrastructure for conditional orders on DeFi. Brink is a fully permissionless, decentralized, and community-driven project that allows users to execute conditional orders against any on-chain liquidity source.
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We’ve done our best to deploy secure code, but Brink has not been audited by a 3rd party. Like any Dapp, use caution, and be aware that there is always a risk of fund loss.