Which is more profitable, holding tokens or providing liquidity on Uniswap?

This article was published on Crypto Valley Live, author: Novum Insights, translation: Li Hanbo.

In the third quarter of 2020, all decentralized finance (DeFi) crypto exchanges began to grow rapidly, primarily due to Uniswap launching a more resilient and deeper version of their exchange platform, which has been online since 2018. Coupled with monetary easing, fiscal stimulus, and an increase in locked assets, this stimulated explosive performance in the second half of this year.

The influx of funds led to the creation of massive liquidity pools, with many seeing the opportunity to earn a 0.3% fee automatically through the protocol, effectively allowing retail investors (not just large holders) to invest. As Uniswap launched a $4 billion liquidity provider fund in early 2021, this began to get serious.

However, unlike the traditional "order book" method of providing asset liquidity, Uniswap and other DeFi exchanges use "automated market making" (AMM). Uniswap's AMM uses a constant product model, relying on arbitrage from external exchanges to balance the liquidity pool composed of two tokens.

You may have heard about LPs and Uniswap.

1. It is full of scam tokens!

Unfortunately, this is true. Anyone can launch a token on the platform without any permissions or high costs, so Uniswap will give you warnings when trading. However, many scammers are still creating "fake" ERC-20 tokens that look identical to real tokens in other respects, luring investors in and then dumping these tokens through (perhaps pre-installed?) swaps. So make sure to check if you are buying the right token before purchasing.

2. You are always losing when the token price fluctuates.

Again, this is basically correct. Since AMM relies on "arbitrage" to eliminate imbalances in the liquidity pool, as a liquidity provider, you are "in the wrong line" with every trade. (Why would anyone want to do this!?) The good news is that with every trade in the pool, you earn new "pool tokens" from the "LP fees" (0.3% of the trade value), which are then used to provide liquidity to the pool. Over time, and as a result of "compound interest," you should ultimately be making money rather than just holding. Well, this is not a "foregone conclusion," and we will see below that you can use the free Novum Insights "DeFi calculator" to check any time period and pairs. Depending on different trading pairs and volatility, you can either make money or lose it. Below, we will delve deeper into this issue. It is worth remembering that these are referred to as impermanent losses because they can reverse, and over time, the fees you accumulate and price corrections can turn into profits. Or they may not. Additionally, when you "win," these are unstable profits, (even with a 50% stable coin pair) can disappear overnight (the real fun of a 24/7/365 global market!), as all your funds are locked in the "token pool" rather than in your hands.

3. My trading pair is "stable," so I have 50% protection against price drops.

So, this makes some sense, but it is not simply loss-proof. We need to consider what happens when the price moves a bit in a "stable/volatile" currency pair. Ultimately, if the value of the volatile token in the trading pair goes to zero in market value, the market will use your liquidity to swap all your stable coins for the zero-value coin. We illustrate the impact of volatility in this type of currency pair in the model below.

4. High gas fees make it unprofitable, and when you need to exit—you can't afford it!

In the summer, gas fees indeed reached 600 gwei at one point, and some token contracts used more gas than others, so even just "exiting" a relatively mainstream currency pair like WBTC/ETH could cost over $160. Prices are driven by demand, and when everyone wants to exit, the prices soar. You should do your homework and consider gas fees as a factor. And check a "gas fee website" (e.g., https://duneanalytics.com/kroeger0x/gas-prices). A brief summary is: 1) If you have a large amount of capital entering, gas fees may not matter (you are lucky!), and 2) ETH 2.0 will fix this issue (we hope!). Otherwise, time your entry with low gas fees.

Goals and Considerations

We started modeling and set some goals, summarized as follows:

Goals

I want to enter mainstream cryptocurrencies—so I want to hold BTC and ETH (rather than a lot of other things I've never heard of) as a start.

I like the idea that my money can earn more fees while I sleep! - Become a liquidity provider.

I worry about it "going to zero"—so I want to have a stable coin in my trading pair to help protect me from this situation.

Model

This model studies the negative and positive behaviors of token pairs in liquidity pools (yes, trading pairs rather than individual tokens) under various market conditions. If you are in a pool, what impact does it have on your fees if one or both of the coins you provide liquidity for go down or up? What impact does it have on portfolio value? If half of the pool is stable, are you really protected or just wasting your time?

We imagine a new investor might want to hold both BTC and ETH while also wanting to hedge with one or more stable coins. We examined extreme cases where one or both tokens' values go to zero or triple, as well as scenarios where one coin's value rises while the other falls, even to zero.

We took a hypothetical amount of $1,000, ignoring all fees, with a total of three pools: ETH/USD, BTC/USD, and BTC/ETH.

Another reason for conducting this analysis instead of some other things is that the two largest liquidity pools on Uniswap (as of now) are ETH/stable coin and BTC/ETH.

Considerations

We ignored some gas fee costs of processes—these can be significant—please calculate your amounts yourself. These costs can and do change the calculations and conclusions, so check your investment amounts before doing anything.

We assume stable coins are 100% stable. This is obviously incorrect, as they fluctuate around $1 (at least a little). For example, DAI has fluctuated between $1.04 and $0.96 over the past 180 days, though this is rare and only lasted a short time. Therefore, to provide meaningful analysis, we assume all stable tokens in our examples remain at $1 regardless. So far, they have done so, but regulatory intervention or platform failure could change this (we hope not).

This is also a model and does not include "real-world data," from more time/data points, or include many other crazy coins and trading pairs.

We assume an annual yield of 22% for liquidity providers, which may greatly exceed or fall short, but there must be some yield (otherwise, why would you do it?). You need to do your own research, and of course, remember that "past performance is not necessarily indicative of future results." Additionally, we also ignored earning fees under real-world conditions of swaps, increases, decreases, etc., and the potential for real-time drastic changes that could affect pools and pricing behavior.

Assuming "arbitrage is effective," it seems to be effective in the case of major tokens. Keep in mind that with other tokens (especially the latest tokens!), they may not be listed on other exchanges or have sufficient liquidity/trading volume, leading to significant volatility. Therefore, "TLDR" refers to the fact that in the smallest pools, whether in liquidity or trading volume, it is not as quick or effective, meaning there are significant gains or losses for those interacting with them.

We assume WBTC and BTC are exactly the same thing. But they are absolutely not, and if you care about this issue, you should do your own research.

All of this assumes that the Uniswap code does not undergo any changes when new versions are released or upgraded to ETH2.0.

Most daily "actions" will be in a tight range on the chart, about +/- 50%, but over time, in special circumstances (i.e., any day of the year in crypto :-), we may reach different extremes on the chart.

Results of Different Analyses

1. Just holding ETH and BTC

This may be the easiest strategy to understand, completely unrelated to Uniswap, but for comparison, we still introduce concepts like relative pricing.

There are three axes to refer to; X is the relative value of BTC, Y is the relative value of ETH, and Z is the value of your $1,000 investment (after all gas fees!). There is no real starting point, but we should start at 100(%), 100(%), $1,000 and then see what happens when the token values rise or fall relative to each other.

Holding equal amounts of Bitcoin and Ethereum

There is really nothing to see here. The gains and losses you get are isolated; they do not affect each other.

2. Providing liquidity for both BTC and ETH

So, this means you hold $500 in BTC/USD (let's call it that) and $500 in ETH/USD. This means that 50% of your total LP is stable tokens, while the rest is BTC and ETH. You gain (but not 100%), but you also incur losses (also not 100%).

Providing liquidity for BTC/USD and ETH/USD, both at equal ratios

So in this case, aside from the steepest declines, you are protected; if one of the tokens in BTC/ETH goes to zero while the other rises, you can still gain from the rise.

Thus, the "wings" on the left and right show this example; if both coins triple, your funds will double. Wait! Why did my two tokens triple in value while my portfolio only doubled? Yes, that's right. Your stable coins are blocking your gains. Remember, they also (most of the time) lead to less severe losses. Similarly, when both tokens go to zero, your portfolio value will also go to zero.

It can be seen that this strategy effectively "hedges" your losses and gains, even if imperfectly, it may suit your risk/reward level. How does it compare to simply holding?

3. Holding BTC/USD and ETH/USD

In this example, we compare the above scenario one and scenario two, leading to two different gain images, one being the flat line in (1) and the other being the wings in (2).

Comparison of holding versus two 50% stable pools

If we do not put them together, we find it difficult to observe the differences, but basically, the "wings" in (2), which include 25% stable coins in each of the two pairs, lead to a downward slope at the edges of the ranges in the chart. In translation, this means that by providing liquidity for pools with stable coins, you are beating simple holding through price increases and compounding fees.

It is worth noting that in the case of both BTC and ETH crashing, you will be protected by the stable effect for a while; however, it will ultimately go to zero. Your decline will be less than what we should mention is just simple holding.

4. Providing liquidity worth $1,000 for BTC/ETH

This is the "moon-me" strategy; you want to hold BTC/ETH tokens while also earning fee income (sounds good!). This is definitely better than just holding them, right?

BTC/ETH running in an AMM pool

Wow! At least it's much more brutal than I imagined. I thought it would be a win-win; the wings decline more steeply than in the "stable" case, which makes sense because if one of the coins you hold experiences extreme market conditions, the AMM and arbitrage mechanisms will "balance it." So how does this compare to simply holding BTC/ETH? Let's take a look.

5. Comparing AMM in BTC/ETH with simple holding

This is a comparison of scenario (1) and scenario (4), where we compare AMM with just holding two unstable (non-stable) tokens.

Providing liquidity for BTC/ETH and simple holding

Interesting. As long as both tokens are rising, the AMM pool performs better than holding, but a sudden drop in one or both tokens will quickly punish you as market trends are interrupted by arbitrage. This indicates that in extreme cases, due to network congestion, you may not be able to execute trades. This is a general rule of automated market making, which means that at certain times (unless you want to incur heavy losses), you must "exit," which will cost "gas," likely at the highest cost. This is interesting; unlike traditional markets, no one can refuse to fill your order. It all turns into paying enough gas fees to write your transaction (see the comments above about gas fees).

Another predictable part is that if both tokens rise, you will gain from the rise and the fees, and of course, this is more than the gains from just the rise. If we are in a bull market phase now, then this is a good strategy.

Let's take a look at the final analysis. How does the bull market strategy compare to two pools with 50% stability?

6. Providing liquidity for BTC/USD and ETH/USD simultaneously vs. all in one BTC/ETH pool.

The following chart compares scenario 2 with scenario 4. Here, it is important that the "double 50%" needs to be in two completely independent pools; otherwise, it won't work.

2 pools with 50% stability BTC & ETH vs. 1 BTC/ETH pool

This is what we have. Perhaps predictably, the approach of having 50% stability and splitting into two pools can prevent all price drops, except for the most severe ones. In the case of one token going to zero, you still have the other pair of tokens. Conversely, when both tokens surge, you will earn significantly less. Of course, if both tokens go to zero, you will ultimately be wiped out.

Conclusion

In summary, providing liquidity to the market may earn more returns in the long run than simply holding. But this is not the case in all situations. You can also configure your liquidity portfolio based on your risk preferences and views on the market's next steps. Stable coins in your trading pair can indeed provide you with limited protection against sharp price adjustments, but they also limit your gains when prices surge sharply.