ELI5: LPs and LPing
Welcome to a series of posts where I attempt to ELI5 (Explain Like I’m 5) some of the concepts that are central to Decentralized Finance (DeFi) and some that are specific to Maverick Protocol. I hope that these explanations will be of some help to users who are new to DeFi.
These posts are provided solely for educational purposes and should not be understood to constitute financial advice.
When I was really young, I was playing in our living room with my childhood friend Jonathan when my mother entered and informed us that she was heading off to the church jumble sale.*
Operating on some kind of whim I don’t fully understand, the younger me handed her one of my toys (I think it was something like a sock monkey) and insisted she take it to be included in the sale.
Later, upon her return from the jumble sale, I asked her where the toy was. She dutifully explained it had been sold at the jumble sale–much to my surprise and disappointment.
Obviously, my mother was blameless in this situation: she had only done what I had asked her to do.
Why am I telling you this story?
Because a lot of first-time LPs undergo a shock similar to the one experienced by young Matthew.
Let’s talk about why.
In my previous ELI5 post, I told you there was one important thing to remember about Automated Market Makers (or AMMs, as I’ll call them from now on).
Pop quiz! What was it?
That’s right! It was that AMMs are dumb.
Remember: AMMs are smart contracts, which means they’re basically software executed by computers (or more precisely, the blockchain), and computers are dumb. Because computers can only do what humans tell them to do. Which means an AMM is only going to do what it was programmed to do.
You’ll recall that AMMs replace the role of a bank or other institution in making markets; that is, they offer to buy and sell assets so that there can be a market for those assets.
In DeFi, we talk about markets in terms of liquidity. This comes from the common financial terminology which calls assets that can be sold easily “liquid assets,” as opposed to non-liquid assets, such as real estate.
We call a market “liquid” if it has plenty of tokens available for trading. You probably remember that an AMM pool is usually composed of two tokens that are traded for each other, so an AMM pool would need to have plenty of both tokens in order to be considered liquid.
As a general term, we refer to the tokens in an AMM or specific pool as “liquidity.” That’s quite a few terms! Let’s recap:
- AMM = Automated Market Maker, a smart contract that uses a set of rules to facilitate trades between tokens
- Pool = a collection of tokens managed by an AMM, usually consisting of a pair of tokens
- Liquidity = the actual tokens themselves contained in the pool managed by the AMM
So an AMM manages pools of liquidity in order to make markets for people who want to trade one token for another.
But where do AMMs get their liquidity from?
Remember, AMMs were invented to replace the fat cats of TradFi whom we’ve decided we don’t like, exchanging centralization and secrecy for decentralization and transparency.
But the good thing about those fat cats is that they have deep pockets and so they can supply plenty of liquidity to a market, even if we don’t necessarily love the power doing this gives them. If we’ve removed the fat cats from the equation, where does DeFi’s liquidity come from?
It comes from Liquidity Providers! (hereafter called LPs, because the only thing DeFi loves more than liquidity is abbreviations)
LPs are people who contribute tokens to an AMM so that it can manage them and make swaps happen for traders.
Who can be an LP? Anyone!
That’s the beauty of DeFi.
Remember, the AMM doesn’t care who you are: only that you have a cryptocurrency wallet and the tokens it needs to make its markets. That’s why we call these markets permissionless.
The general idea is that liquidity for DeFi markets is sourced from the community, with hundreds or thousands of little wallets working together to make large markets that can serve the needs of the community as a whole.
Of course, you still get fat cats in DeFi (though we call them “whales”).
The difference is that the activity of these whales is completely transparent, and they’re governed by the same immutable AMM rules as everyone else. No whale can enter or leave a market without everyone being able to see them do it, and they don’t get any special treatment from an AMM.
Because, of course, AMMs are wonderfully, beautifully dumb.
This post is going a bit long, so let’s answer two questions and then bring it to an end:
- Why would anyone want to be an LP?
- What does any of this have to do with sock monkeys?
1. Why would anyone want to be an LP?
Like I suggested above, there’s an element of altruism to liquidity providing: being an LP is a public good, because without liquidity there is no DeFi.
But LPs don’t just do it for the rosy glow. They do it because they expect some compensation in the form of fees generated by the AMM.
Most AMMs will charge traders a fee per swap. This is usually calculated as a simple percentage of the swap. For example, let’s say a particular AMM pool has a fee of 0.01%. This means if a trader asks to make a swap worth $100, they will have to pay the AMM $0.01 as a fee. This fee is used to compensate the LPs that make assets available in that pool so that the swap can happen.
The fee percentage is one of the rules that govern an AMM. Once a fee is set, the AMM will charge every trader the same percentage fee, regardless of who they are or the size of the swap. The AMM can’t make any special exceptions or charge more or less than the set fee. Because the AMM is dumb.
2. What does any of this have to do with sock monkeys?
Okay, remember 5–10 minutes ago when I told you my tale of woe: how a young Matthew had given his sock monkey to his mother to sell in a jumble sale and was surprised when she sold it?
Like I said when I told you that story, this is a surprise I’ve seen a lot of first-time LPs experience.
Before you provide liquidity to an AMM, it’s important you understand what LPing is. It is not investing. It is not like putting money into a savings account. It is not like buying stocks.
When you provide liquidity to an AMM, you are giving the AMM your tokens so it can sell them.
Remember, the AMM is dumb. It exists to make trades happen. It looks at its pool of tokens, sets a price, and then makes swaps with whoever wants them.
When you provide liquidity to an AMM, you are handing your tokens to a dumb computer program that only exists to make trades happen.
Let’s say you provide ETH to an AMM pool made of ETH and USDC. If people want to swap USDC for ETH (for your ETH, no less), the AMM will make the swap.
It doesn’t matter if now is a good time to sell ETH. It doesn’t matter if there’s a bull run happening and now would be a good time to hold ETH.
The AMM doesn’t know. The AMM doesn’t care. It just exists to follow its rules and make swaps happen. If it has the liquidity and traders are satisfied with the price, it will make trades all day.
Now, it’s not like the AMM is simply giving your ETH away: it’s taking in USDC as part of the swap. And the AMM will remember that this is your USDC. So if you ask for your money back, you can rest assured you’ll receive something. But it’s likely that it won’t be the same asset or mixture of assets that you originally provided.**
Because LPing is not investing. It is giving tokens to an AMM so that it can offer them for trading.
If you take nothing else away from this tale of monkeys, cats, and whales, let it be this: LPing is not investing.
So many first-time LPs miss this fundamental point, and are shocked when the assets in their portfolios shift in response to trading with the AMM.
But you won’t be shocked–because you’ve read this blog!
Next time, we’ll start diving a little deeper into how AMMs set prices and track the tokens belonging to each LP in a pool. Thanks for reading!
* — I believe this is known as a “rummage sale” on the other side of the pond.
** — This might go without saying, but of course the AMM will also sell your new USDC back to ETH if that’s where trade flow moves. As long as your tokens are in the pool, they will be traded back and forth as often as traders show up and ask for them.
