TO LP OR NOT TO LP

Greetings Lefties,

As we've shared in our previous Substack, we believe yield farming to be the superior way of participating in DeFi. In TardFi, Liquidity Providing (LP) is done by market makers like Flow Traders and Virtu with the crypto equivalents being Wintermute and B2C2. What market makers do is ensure you will be able to trade at market prices while earning a profit with the bid-ask spread. With the innovation of the Automated Market Maker (AMM), it lowers barriers to entry and you can be a market maker too. Liquidity Providing in crypto is essentially allowing an individual (you) to act as a market maker enabling trades on automated market maker platforms like Sushiswap and Uniswap. By doing so, you get a cut of the fees and rewards as well as rewards from the protocol you are LPing for. 

This is the promise of crypto, instead of the value accruing to centralized entities the rewards accrue to users actually providing value. 

We often get the questions: What should I do with my coins? Should I stake it? Should I LP? What about Impermanent Loss (IL)?

The answer is .....

We can't answer for you since different people have different needs, priorities, and portfolio sizes. Different pairings also have different yields and correlations resulting in varying risk factors. But we can provide you with the options and framework to decide if it's worth it.

Single-sided staking

An option for your coins is to stake it with the protocol for governance rights (voting) as well as to participate in rewards that come from revenue earned by the protocol. 

Pros:

No IL

Revenue earned

Cons:

Smart contract risk

Lock-up period for certain protocols

Often lower APR than LP

Single-sided staking is often the choice for those who are afraid of the two words that shall not be spoken:

Impermanent Loss

We want to dismiss most people's fear of IL when it comes to LP’ing. 

Impermanent loss is a decentralized finance (DeFi) phenomenon that occurs when an automated market maker’s (AMMs) algorithmically driven token rebalancing formula creates a divergence between the price of an asset within a liquidity pool and the price of that asset outside of the liquidity pool. If you like to understand more about IL, you can do it here.

In simple words, IL occurs when the price of tokens deposited into the pool does not change at the same rate, resulting in you having less of the token which performed better in price. 

How much less though? How bad will the IL be?

Using the IL calculator we can establish a few scenarios of IL:

1.5x price change against the other coin =  2.02% IL

2x price change against the other coin = 5.72% IL

3x price change against the other coin = 13.4% IL

4x price change against the other coin = 20% IL

5x price change against the other coin = 25.46% IL

10x price change against the other coin = 42.5% IL

20x price change against the other coin = 57.41% IL

Calculator Example:

So you need to take a look at both tokens and ask yourself: “What do I think is the probability of the above scenarios occurring?”

Let's take a look at how to make a decision considering the variables of time horizon, correlation, and probability

Time Horizon

Do you believe in both coins and how long are you prepared to hold? 

We do not think LP’ing is suitable for a less than 1-month time horizon. 

Let's take a look at the returns from LP’ing for SPELL-ETH (which at time of writing is 125% APR vs 25% APR single-sided staking) over the next 3, 6, and 12 months with daily compounding, ceteris paribus.

3 months

That would yield ~36% over 3 months. Single-sided staking would yield ~6% over the same period.

6 months

That would yield ~86% over 6 months. Single-sided staking would yield ~12% over the same period.

12 months

That would yield ~248% over 12 months. Single-sided staking would yield ~25% over the same period.

Correlation

For large-cap coins, it would be helpful to make use of correlation in making a decision. Correlation determines the degree to which the price of one coin would move in relation to the other. For example, a positive correlation coefficient of +1 would mean that if 1 coin is up 10%, the other would be up 10% as well. A negative correlation coefficient of -1 would mean that if 1 coin is up 10%, the other coin would be down 10%. In reality, we rarely see perfect correlations. Ideally, we'd want both our coins to have a positive correlation coefficient of at least +0.6.

However, for many smaller cap coins that we LP for, we might not be able to find the correlation coefficient for, this is when we try to evaluate probabilities of a deviation in coin prices.

Probability

Anything is possible but what is the probability? Again taking SPELL as an example, the market cap at the time of writing is $1.6B relative to its competitor MKR which has a market cap of $2.2B. In the next 3-6 months, do we expect SPELL to do a 2x? 3x? 5x? 10x? What would the market cap be at those multiples?

2x - $3.2B

3x - $4.8B

5x - $8B

10x - $16B

Taking macro conditions into consideration, it is unlikely for SPELL to do a 5x with ETH prices staying constant. This means we need to look at SPELL prices relative to ETH. In its parabolic move against ETH from 3rd Oct, it was ~4x.

Taking into account yields over the next 3-6 months in a 3x or 5x scenario, we can comfortably outperform IL of 13.4% and 25.46% respectively with an ROI of 36% and 86%.

As an example, if we were to assign a probability of 30% chance of SPELL 5x against ETH in the next 3-6 months, we can choose to single stake 30% and LP 70% of our SPELL instead of avoiding it altogether due to fear of IL.

We intentionally chose SPELL as an example as it is one of the coins that has severely outperformed relative to ETH in recent months to better illustrate the effects of IL.

Other Considerations

Depending on the amount of money you are working with, you should always find out the optimum time to compound your returns. This would largely depend on gas fees at that point in time as well. If working with an amount of less than 7 figures on Ethereum L1, it would mostly make sense to either use an autocompounder like Pickle or move to an L2 like Arbitrum or sidechains like Avalanche, Fantom, or Matic. Here is a calculator you can use to calculate the optimum compounding period. 

This framework should help in your decision to LPing but do take note that this might not apply for degen yield farming, which we would cover in the future.

TLDR

IL is real but that should not deter you from taking calculated risks causing you to lose potential yield. LP’ing should not be done with a short time horizon hence it’s important to zoom out when looking at LP and IL. If APR is high enough, it should outperform IL in most instances. Ultimately, the pair should be of coins you believe in and are willing to hold long-term and LPing would be able to help in accruing the coins with limited US token cashflows.

If you have friends on the middle of the curve, send this to them to help them slide down to the left/right.

Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are *opinions* written by an anonymous cartoon villains for educational purposes.