May 30th, 2024 by Chrispyman
In the world of decentralized finance (DeFi), providing liquidity to automated market makers (AMMs) can be a highly lucrative strategy. There has been a lot of speculation about pStables pegging to a dollar. This blog post will explore how an initial investment of $300 in a pDAI/pUSDT (or other pStable pair) liquidity pool can potentially grow to a substantial amount, assuming specific market conditions are met (i.e. pStables appreciate to $1), compared to holding the tokens liquid. We will cover the concepts of AMMs, impermanent loss, trading fees, price appreciation, and ultimately, the final return on investment (ROI).
Understanding AMMs
Automated Market Makers (AMMs) are the backbone of decentralized exchanges (DEXs). This includes Pulsechain and its primary DEX PulseX. They facilitate trading by maintaining liquidity pools where users can trade tokens without needing a traditional order book. AMMs use smart contracts to manage these pools, operating on a constant product formula, typically represented as x * y = k. Here, x and y are the quantities of the two tokens, and k is a constant. This mechanism ensures that the product of the quantities remains constant, which adjusts the token prices dynamically based on supply and demand.
Impermanent Loss
Impermanent loss is a phenomenon that occurs when the price of tokens in a liquidity pool changes relative to their price when deposited. It represents the opportunity cost of holding the tokens in the pool versus holding them individually. The loss is "impermanent" because it is only realized if the tokens are withdrawn when their price ratio has changed. If the prices return to their original ratios, the loss can be mitigated.
Trading Fees
Providing liquidity earns LPs trading fees from each transaction that occurs in the pool. These fees are typically a percentage of the transaction value and are distributed proportionally to LPs based on their share of the pool.
Initial Position
Starting with an initial investment of $300, we will split the investment equally between pDAI and pUSDT:
$150 invested in pDAI
$150 invested in pUSDT
Calculation of Initial Tokens
To determine the number of tokens acquired with the initial investment:
$150 invested in pDAI at $0.003671 per token results in approximately 40,869.09 pDAI tokens.
$150 invested in pUSDT at $0.002035 per token results in approximately 73,696.68 pUSDT tokens.
Growth from Trading Fees
We assume a trading fee of 0.22% and an average annual percentage yield (APY) between 5% and 30% from these fees. This additional APY from trading fees could grow the value of the LP position over one year and beyond. Since the exact amount of fees is not determinable it is excluded from the Final Value Calculation and would be in addition to the figures below.
Final LP Value Calculation
Assuming both pDAI and pUSDT appreciate to $1 each in a linear fashion:
The final value of pDAI tokens would be 54,880.35 tokens multiplied by $1, equating to $ 54,880.35.
The final value of pUSDT tokens would be 54,880.35 tokens multiplied by $1, equating to $ 54,880.35.
Adding these together, the total final value of the LP position would be $109,760.70.
Final LP ROI
The final return on investment (ROI) is calculated by subtracting the initial investment from the final value, dividing it by the initial investment, and multiplying by 100 to get a percentage. In this case, the ROI is approximately 36,487%. Additionally, the ROI could be higher depending on how individual pairs perform and the Actual Percentage Rate (APR) earned from fees.
Holding Liquid Value Calculation
Assuming both pDAI and pUSDT appreciate to $1 each in a linear fashion, holding the tokens liquid might result in:
The final value of pDAI tokens would be 40,869.09 tokens multiplied by $1, equating to $ 40,869.09.
The final value of pUSDT tokens would be 73,696.68 tokens multiplied by $1, equating to $ 73,696.68.
Adding these together, the total final value of the LP position would be $114,565.77.
Final Holding Liquid ROI
The final return on investment (ROI) is calculated by subtracting the initial investment from the final value, dividing it by the initial investment, and multiplying by 100 to get a percentage. In this case, the ROI is approximately 38,089%.
Conclusion
This case study highlights the significant potential returns from providing liquidity in a pDAI/pUSDT pool, given specific market conditions. Starting with an initial investment of $300, the position could grow to approximately $109,760.70 (plus fees), assuming the tokens appreciate to $1 each. While these returns are impressive, it is crucial to understand the risks, such as impermanent loss, and the mechanics of AMMs.
Holding tokens liquid avoids the risk of providing liquidity by eliminating impermanent loss. Starting with an initial investment of $300, the position could grow to approximately $114,565.77.
This amount is +4.3% higher than providing LP but foregoes any fees which might have been earned by participating in the market. Note that APR from providing liquidity could be substantially higher (or lower) than the 4.3% specified above.
Crypto currency is inherently risky. Liquidity provisioning in DeFi offers substantial rewards, but it requires careful consideration of market dynamics and investment strategies. By understanding these elements, you can make more informed decisions and potentially maximize your returns in the evolving DeFi landscape.
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