In this article the iYield team is presenting you with an article about a market for LP tokens — Yield Bank will be at the forefront of the inception and development of this subsidiary yet very key market. In our previous article (which you can read here) we have defined what an LP token is, but let us quickly refresh our memory.
LP token is an ERC-20 token you get in return for providing liquidity on Uniswap. You can think of it as a sort of IOU coupon or a receipt. In essence, the amount of LP tokens you were given represents the value of the money you put into the liquidity pool.
Uniswap’s LPs
Uniswap LP tokens are minted when a user joins the pool and burned to withdraw from the pool. The rate at which they are minted and burned is such that you will always be able to withdraw your proportional contribution and your proportional share of each fee since you joined.
Issuance rate of LP tokens
So how exactly am I supposed to know how much LP tokens I will be getting back in return for this or that amount of liquidity I put in?
Courtesy of Uniswap’s whitepaper, this calculation is actually quite simple.
Uniswap v2 initially mints shares equal to the geometric mean of the amounts deposited:
Where x is the nominal amount of the first token deposited (regardless of its relative USD value) and y is the nominal amount of the second token.
To give a practical example, lets say for the initial liquidity deposit a user or a developer would deposit 100 ETH and 46,000 USDT.
Assuming that the market price of 1 ETH at the time is $460 and the ETH/USDT pool has an enforced 50–50 ratio when providing liquidity to it. The math would then be as follows:
S minted = Supply of LP tokens minted
46,000 * 100 = 4,600,000
You take the square root of that which is √4600000 = 2,144.76~
S minted = 2,144.76~
This means you would get 2,144.76~ LP tokens as the initial liquidity depositor for depositing 100 ETH + 46,000 USDT.
The above formula ensures that a liquidity pool share will never be worth less than the geometric mean of the reserves in that pool.
Yield Bank’s LP model
Yield Bank’s LP model based on the base functions of CORE is such that you cannot withdraw your liquidity. When you decide to provide liquidity to any of our pools, that money will be there locked forever.
The LP token you are given in return for doing so is then used to represent the value of the liquidity you provided as well as the passive income aspect the LP token possesses. In essence, you use and trade the LP token instead from that point onwards. The first obvious positive that comes from this model is that instead of having to move two different assets around, you now only have to move one.
The positives of having an LP market
So what is a proprietary LP market even good for?
Let’s start with a practical, very simplified example.
An ETH-DAI liquidity pool has 1 user in it —Jennifer. Jennifer put in such amount of ETH-DAI that she was given back exactly 50 LP tokens. Since there is only this one user in the pool providing liquidity, she owns 100% of the pool and therefore is entitled to 100% of the rewards.
Second user, Alyx, comes in and puts in such amount of ETH-DAI into the pool that she was given back exactly 500 LP tokens. The total pool is now worth 550 LP tokens, Alyx therefore owns 90.9%~ of the pool and Jennifer owns 9.1%~ of the pool.
Since Uniswap distributes fees proportionally based on the ownership of the pool i.e. ownership of the LP tokens, Alyx now gets 90.9%~ of the rewards while Jennifer went from having 100% of the rewards to having only 9.1%~.
In other words, as the pool grows and other users come in, the rewards you will receive overtime will proportionally decrease. This has positives and negatives.
The positives being that as a liquidity pool grows, it becomes more stable and trusted thus reducing risk. Basic game theory suggests that pools with more money in them are safer since if it was possible to hack them and drain or freeze the funds, as long as the potential profit for the attacker outweighs the costs of executing the attack, the attack would have already happened. The longer a protocol, a specific product or a specific pool functions without any issues, the less likely it is to malfunction or be hacked.
The negative is, as game theory and basic economics would suggest, that when the risk decreases so do the rewards, in this case quite literally. In other words, as the pool grows and you still own the same amount of money you put in (not accounting for impermanent loss) but with that same share, you are entitled to fewer rewards (assuming you did not put in additional liquidity on top of the liquidity you were already providing).
When these rewards decrease, in the case of the traditional LP token model of Uniswap, you can simply up and leave — withdraw your money from the no-longer-profitable pool and put it into a different liquidity pool.
In the case of CORE’s LP token, this is not possible as you are now using and trading the LP tokens instead.
This is where the LP market comes in.
LP market inception
Suddenly, there is a need to be able to trade these tokens in an easily accessible, liquid market. LP token’s value will fluctuate based on many things such as market conditions, price swings of the underlying assets, increasing or decreasing rewards in each epoch and so on.
This creates massive financial opportunity for everyone, from the most basic cryptocurrency user to professional traders and (automated) arbitrageurs.
Further, LP tokens are passive income assets that, if generated off the appropriate long-term oriented liquidity pool such as Yield Bank’s liquidity pools, will provide stable incomes for years to come — years of stable income in crypto is comparable to decades of appreciating index funds in traditional finance, given how fast the crypto market moves and evolves.
We will create a market for LP tokens on our platform.
Labeling of LP tokens on our Yield Bank platform
With the creation of a new market, users will need to be able to track these new passive income assets for easy portfolio management and comfort when trading and transferring these LP tokens.
With the ever-expanding variety of liquidity pools the current DeFi space offers, we have set out to simplify not only portfolio tracking but tracking of LP tokens in general. Through our platform we will be able to label LP tokens so that users won’t have to use external portfolio trackers if they happen to have several LP tokens from different pools to make sense of what LP token belongs to which liquidity pool.
This will be achieved with the help of our IAP (Individual Account Propriety) technology thanks to the database layer we have built on top of the Ethereum network.
We have more to say on this topic in the future! Stay tuned.
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The article and any other associated content of Yield Bank does not constitute as financial advice. Cryptocurrencies are a high risk investment and may not be suitable for all members of the public and all types of investors. This is an experiment in DeFi yield aggregating to bring longer and steadier yields to its users.
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Liquidity Episode date: TBA
