Liquidity pooling explained

I've seen multiple people trying to grasp how liquidity providers make money, what is impermanent loss, how to pool, etc. I thought it could be of interest to share an eli5 here. To pool in uniswap, you need to provide equal value of any 2 assets. The bigger the pool, the better is the liquidity and the more the pool will be used to transact because slippage will be smaller.Small pool = high slippage (transactions make the price vary a lot)Big pool = low slippage (transactions do not make the price vary a lot)DEX are usually coded to limit as much as possible the slippage, as to give you more bang for your buck. It is for that reason that Uniswap might make you do (random example) eth -> usdt -> link instead of eth->link. The eth-link pool might be small, while the eth-usdt and the usdt-link pools are both massive and you will get more bang for your buck by transacting through those 2 pools.What is impermanent loss.You have given equal value of eth and uni to start with (you pooled eth-uni).Eli5, when people buy uni from you, they give you eth.When people buy eth from you (with uni), you receive uni. Basically you're always accepting the trades because you're providing liquidity.You gain a small amount of fees on every trade, according to your share of the pool.It is basically the same as if you'd sell your uni all along the price rise or buy uni all along the price drop.Since the price has risen a lot, you "sold" a lot of uni to people and gained according eth. Because you sold uni along the way, it is basically like if you sold a bit of uni at 4$, then 4.01, then 4.02, etc.When the price moves too fast, the loss you make by "selling along the way" isn't compensated by the small fees you receive. That is impermanent loss, basically if the price drops back down to when you pooled, you will be winning from the fees. Or if the coin keeps moving and eventually stabilizes and trades for a long time at that price, you will accrue fees that will make up for the impermanent loss.Hopefully it helps. If you don't quite get it still, please post your questions and I'll do my best to get it clearer for you :)

Submitted November 17, 2020 at 02:15PM