When you add your token to a Liquidity Pool you will receive Liquidity Provider (LP) tokens and share in the fees.
As an example, if you deposited ETH and CFX into a Liquidity Pool, you'd receive ETH-CFX LP tokens.
The number of LP tokens you receive represents your portion of the ETH-CFX Liquidity Pool.
You can also redeem your funds at any time by removing your liquidity.
Liquidity Providers Earn Trading Fees
Providing liquidity gives you a reward in the form of trading fees when people use your liquidity pool.
Whenever someone trades on Swappi, the trader pays a 0.25% fee. Of that fee, 0.17% is added to the Liquidity Pool of the swap pair they traded on.
- There are 10 LP tokens representing 10 ETH and 10 CFX tokens
- 1 LP token = 1 ETH + 1 CFX
- Someone trades 10 ETH for 10 CFX
- Someone else trades 10 CFX for 10 ETH
- The ETH/CFX liquidity pool now has 10.017 ETH and 10.017 CFX
- Each LP token is now worth 1.00017 ETH + 1.00017 CFX
To make being a liquidity provider even more worth your while, you can also put your LP tokens to work mashing up some yield boost Staking PPI Click here to jump to the how to farm page, while still earning your 0.17% trading fee reward.
An Important factor that must be discussed is the potential for impermanent loss. Impermanent loss is the change in value of both underlying coins value compared to when you deposited them to create the LP token. Lets walk through an example:
- 1 ETH = 10 CFX and 1 CFX equal to $1 USD
- You deposit 1 ETH and 10 CFX for a total of $20 worth of tokens to create an LP token
- Your 1 ETH-CFX LP token is 1% of the pool
- The total amount of ETH in the pool is 100 ETH and there is 1,000 CFX in the pool as well for a total of 100,000 worth of coins in the Liquidity pool
- After some time trading the total liquidity in the pool is still 100,000 in liquidity but the prices have changed for each coin
- ETH is now worth 40 CFX while CFX is still the same 1 CFX = $1
- The changes in values means the ratio of assets per LP token will change because of the nature of an automated market maker exchange. Arbitrageurs will change the total amount of tokens in the pool but the pool will be the same amount of liquidity.
- Previously the ratio was 10 CFX: 1 ETH Now the ratio is 40 CFX : 1 ETH
- The pool is still $100,000 but there will be 50 ETH and 2,000 CFX
- You withdraw your liquidity from the pool so you get 1% of the pool. Therefore you receive .5 ETH and 20 CFX back for your assets
- Since the value of the tokens rose your .5 ETH = $20 USD and your 20 CFX = $20 for a total of $40. That's a 100% return not bad but....
- If you had held on to the original amounts of your tokens you would have
- 1 ETH= $40 + 10 CFX = $10 for a total of $50
- the $50-$40 is what is called the impermanent loss
Impermanent loss really should be called ratio loss because the impermanent loss is more pronounced as the change in the ratio of assets increases. Why would you risk impermanent loss? Remember that each trade done on your LP token assets, in our previous example ETH-CFX, has a .25% fee. .17% of the fee is paid out to the LP token holders. The fees are meant to more than offset the losses caused by impermanent loss.
There is a great article from Binance that goes into deeper detail about impermanent loss. Click here to go the link.