The axiom is old – certainly older than crypto investing. It is both a warning and an enticement to investors. If you take a greater amount of risk, you have the potential for a greater amount of reward. And, if you seek a more significant reward, you are adopting a more significant amount of risk. In traditional investing, it has held true enough that the saying stays alive. Mutual funds of comparable investment profiles (ie: growth, value) are compared to each other not just by their past returns but also their risk profile. An investment that has moderate returns but low risk, is more desirable than one that has moderate returns and a high-risk profile.
So, what does this have to do with liquidity mining? The recently published journal article “Behavior of Liquidity Providers in Decentralized Exchanges” (Heimbach, Wang and Wattenhofer) seems to turn at least some of the risk/reward adage on its head. The paper is a report about their empirical study of Uniswap LP investors, to determine, among other things, what types of investor provides liquidity to markets and what the relative returns of different types of liquidity currency pairings were.
As a newer investor to crypto, it was interesting to read the parts of the study dealing with the types of investors who comprise the liquidity pools. They determined that most of the Uniswap LPs were investing in one pool, and those LPs account for more than half of the liquidity in the DEX. They assert that “This fact suggests that DEXes are not controlled by oligopoly and professional market makers. Ordinary users contribute the most to the healthy operation of the decentralized market mechanism.”
The part of the article that was most interesting to me though, was about the risk/reward profile of some of the studied pairings of cryptocurrencies. It’s fairly well established that LPs are paid when trades are made within the cryptocurrencies that comprise their liquidity pool. Returns can be diminished, through impermanent loss, when there are significant changes in the price of those cryptocurrencies. This paper includes pretty dense formulas for how this works, so anyone who is fantastic at math and curious might find that part of the paper quite interesting. But, the overall concept is important to understanding how the risk/reward profile may be affected.
They studied three types of liquidity pairings: stable pairs, normal pairs and exotic pairs. We’ll start with the stable pairs. Not surprisingly, when stable coins are paired, their ratio of price change is very… well, stable. For frame of reference, one example that was used was USDC/USDT. These both track the dollar and so, barring something quite unexpected, they track with each other price-wise, over time. This means that there is a tiny amount of exposure to impermanent loss. The most significant factor in returns for these pairings is a positive one. That is through the fees generated by trades into the pool. When there are lots of trades between the two coins, then the returns are greater, and when there are fewer trades, they are smaller. Because there is almost no exposure to impermanent loss, negative daily returns during the period studied, were almost non-existent. The quote that they used to sum up their description of the risk profile for stable pairs was “… providing liquidity in stable pools appears almost risk-free with consistent and stable revenue.”
Next, they looked at “normal” pairings. This category of pair is more heavily influenced by the effects of impermanent loss. These pairs have a higher degree of volatility than the stable pairs did and so they have more significant fluctuations between average daily returns. These fluctuations were sometimes positive and sometimes negative. UNI/WETH had some daily returns that were approximately .75% but then also had some that were roughly -.75%. The same was seen within the other studied normal pairings.
Based on this study, the exotic pairs should come with a warning label! The most significant factor in returns for this group was a negative one. Impermanent loss was the dominant factor in these trading pair. The authors observed impermanent losses of 70% during the four-month study period! Fees generated by trading were no match for these significant losses. One statistical measure that they used, called conditional value at risk (CVaR), showed that the studied pairs not only had the highest level of risk; they also had the lowest average returns.
And, this is why it seems that in some cases, the risk/reward profile that exists in other markets, may be turned around in some liquidity mining ventures. This is not to say that these results will be replicated in other pairings or even within these pairs in the future. Like the other saying goes- past performance does not imply future results. But, it does appear logical that if you are invested in a pair that does not have significant changes in price, and has significant volume in trading, that you should enjoy generally positive returns.
I’m not an investment advisor or professional in the industry. I’ve just started investing small amounts in crypto in the past few months. So, please take that into consideration. I’m publishing this because the article was helpful to me and I thought that I might pass it along to other folks who are trying to get an understanding about this type of investment.
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