Providing Liquidity to DEXes

A liquidity pool is a pool of tokens locked in a smart contract and used to facilitate decentralized trading or other DeFi activities. Liquidity pools for decentralized trading became widely popularized by the Uniswap protocol. This basic type of liquidity pool holds two tokens in its reserves and creates a decentralized trading venue for the token pair according to a constant product market maker formula.

When liquidity is added to a pool, the liquidity provider (LP) receives special tokens called LP tokens representing the liquidity supplied to the pool, relative to the total size of the pool’s reserves. A LP Token will contain a proportional share of the constituents of the pool according to the reserves of each asset on the pool.

When providing liquidity, some users choose pools of Stablecoins in order to avoid impermanent loss. These pools are quite popular among the community and normally consist of two different Stablecoins pegged to the $USD. As these assets are supposed to maintain the $1 dollar value, liquidity providers will earn trading fees and some liquidity mining rewards, increasing their initial investment. But is this always true?

RISKS of Providing Liquidity to DEXs

The main complication is the loss of peg from one Token of the pool, meaning that the pool gets unbalanced. In this case, the reserves of the pool are no longer 1:1, thus there will be more of one token than the other. In this case, the LP provider will retrieve less USD than initially provided, since one of the tokens that was bought for 1$ is now worth slightly less.

Epsylon Solution

In these cases, we convert the profit generated by the strategy into more LP to increase our position, and reduce the losses generated from the unbalancing of the Pool. During the time a pool is unbalanced no profits are shared with the Vault users. (As mentioned before, this is used to rebalance the position and preserve the funds).