You heard about Uniswap, a decentralized exchange (or an automated market maker) and you want to dip your toes. You might have already done so, but are not sure you had, or saw any benefits as opposed to just hodling a token. In this article, I want to point out some interesting advantages using it, that are not so obvious but can be observed through a real life example below. The findings are of course applicable to other decentralized exchanges (DEX) as well, not just Uniswap.
How does a DEX like Uniswap work and what are its appeals? There are many articles explaining how to use it so let’s just summarize quickly. In its essence, a market pair on Uniswap is actually a smart contract which always fulfills the following condition:
Quantity of token A * Quantity of token B = Constant
Swapping token A for token B will increase the the amount of token A and decrease the amount of token B in the pool, changing their ratio (effectively price).
With a DEX like Uniswap, you don’t need a login or do KYC to use it, you simply connect one of the supported wallets and use its interface, primarily for the following purposes:
As a trader: Traders don’t buy or sell tokens, but rather swap them. The difference being that you cannot create limit orders on a DEX since there is no order book. You swap your tokens based on the current ratio of one against the other. (Market orders on a CEX are essentially similar as swapping on a DEX, provided there’s decent liquidity in the book).
As a liquidity provider: Using your connected wallet, you decide to provide an equal amount (valued in USD) of both tokens into the pool. In return, you now own a certain percentage of the pool and collect 0.3% of fees from swaps, proportional to your pool percentage.
I want to discuss the second use case.
Let’s take a look at a concrete example. I’ve been participating in the liquidity pool of Vectorspace AI (VXV), an interesting project you can check out here. I Joined the pool on the 21st of January 2021, below is the CoinGecko price/volume chart of VXV from that date until today. A short period of stagnation was followed by a x2.5 pump, followed by a an ongoing period of trading within 70–90c range with a lot of zig zag volatility as visible on the chart:
I have also kept a sheet I updated daily with the stats from my Uniswap account (you can view it here) and below are some interesting findings.
Impermanent or divergence loss
The biggest fear from typical investors called HODLers ;) is the impermanent or divergence loss which occurs, if token A gains multiples in price against token B. There is a rule of thumb: If you provide liquidity, and token A gains 4x in price against token B, you will loose about 25% of your pooled token A.
The sentence, that is usually missing here is, you will also gain a proportionate amount of token B in return. Let’s check the numbers:
At the peak price of about 1 USD, My pooled VXV stash dropped from 64K to about 45K VXV resulting in 30% divergence loss. At that same point in time, my pooled ETH stash increased from 19 to 30ETH which was 58% increase. As of today, 10 days later, my token balance is 56K VXV and 26.3 ETH. If I exited the pool now, my divergence loss on VXV would be 12.5%. Here is the chart, showing how my quantities of ETH and VXV changed over time:
We can deduct two things at this point. First, it is important when to enter or exit the pool, depending on what you want to achieve. If my goal was to maximize my ETH, a good exit point would be at the end of the pump. Second, your tokens ratio will swing around quite a lot, but does it matter? Read on to find out.
POOL vs HODL strategy
I often hear “it would have been better if I simply HODLed my token”. But is it? It most certainly would be, if all token A did was grow constantly. But it doesn’t. Let’s compare the two strategies in this real life scenario:
USD value of HODL strategy on a given day is calculated as:
starting ETH * daily ETH price + starting VXV * daily VXV price
Value of POOL strategy is calculated as:
current ETH * daily ETH price + current VXV * daily VXV price
I entered the pool with 64000 VXV and 19 ETH. The orange line in the chart below, represents the difference between HODL and POOL strategies. I also marked areas in both charts where one performed better than the other (red = POOL, blue = HODL)
As you can see, HODL strategy performs better only in the time of immense growth, but even then, not by much (compare red and blue line). POOL strategy is a long term strategy where slight volatility which increases volume is your friend while high price jumps/falls are not. What you may also notice is that participation in liquidity pool also gives you some degree of dump protection. If a token suddenly drops immensely, those who are swapping out to get ETH, have to pay you an ever increasing amount of that token as its price drops. And every fall has a bounce back.
Looking at the lower part of CoinGecko chart, you can see the spike in volumes. There is one important metric I unfortunately wasn’t tracking in my own spreadsheet, but I can offer some ballpark figures:
volume / pool size
The higher the value of this expression, the more utilized the pool is, the more fees are collected, which makes it more attractive for liquidity providers. As a liquidity provider you strive for both high percentage ownership of the liquidity pool and a high volume/pool ratio.
At the time of volume spike, when VXV-ETH pair volume reached over 2 million USD, this ratio was about 6 (volume was 6x larger than pool size), and even though, I only owned about 25% of the pool, I received a lot more fees then at the start, when I owned almost 2/3 of the pool but volumes were lower. After the spike, volume/pool dwindled to about 1:1 which for me is still an acceptable ratio.
When deciding on which pools to join, this metric is important as it determines the amount of fees generated from swaps, however, it should NOT be the only metric. If you see some XYZ token you know nothing about, you see it has good volume, you buy a bunch, then you throw your ETH and XYZ into the pool. Cash cow in the making right? Well, it just so happens, you didn’t research the token XYZ and unfortunately, the ICO price was 5% of what it is now, and you also missed the information that there is a daily inflation of 300K tokens. What happens next is, everyone swaps out ETH, leaving you with a mountain of worthless XYZ you can’t do much with. So always… invest time and DYOR ;)
For the foreseeable future I will remain a liquidity provider in the VXV-ETH pool. I see it as an interesting experiment, and already, committing to the POOL strategy has given me 7% better returns even after VXV went through a 2.5x pump, and this will only diverge further in favor of this strategy as time passes. I consider being a liquidity provider on Uniswap is also a better alternative than staking of assets, which is what some centralized exchanges offer to attract clients. Staking is usually only available on selected assets, returns vary from 7–12% annually, and while providing liquidity on Uniswap is limited to ERC20 tokens, there are many more options and good opportunities if one is willing to find them. The downside being relatively high transaction fees lately as ETH network is becoming congested. This will be remedied with appearance and adoption of competitive blockchain solutions.