Liquidity Provision on Solana

Introduction

Liquidity provision (LP) is a way to earn yield on your assets while supporting market health. This article will summarize liquidity, how LPing works, risks, and different strategies you can implement based on portfolio goals.

What is liquidity?

Liquidity is the lubricant which makes markets work smoothly. In terms of trading, liquidity refers to how easily an asset can be bought or sold. If a market has high liquidity it means there are a lot of participants/capital, if a market has low liquidity there is a relative lack of participants/capital. For low liquidity markets difficulty for traders may emerge in the form of slippage. Since there is less capital/participants in low liquidity markets it is harder to find counterparties to match bid/asks so traders end up paying or selling higher or lower than mark price. This difference from mark price is called slippage, the idea being the amount your order caused the price to “slip” or change from mark. Another way difficulty could emerge would be in longer fill time. Improved liquidity allows markets to price more efficiently, supports stability and overall improves investor confidence. 

If your market has low liquidity what do you do?

In traditional markets liquidity is improved by market-makers. Market-makers are firms that provide liquidity to assets so that traders always have a counterparty. Market-makers are incentivized to market make through the profit derived from the bid-ask spread, although for some markets extra incentives are contractually added such as reduced fees or exclusivity in order to encourage market making. Exchanges or assets will do this to improve asset liquidity, reduce volatility and overall support investor confidence.

In crypto there are thousands of assets with markets that are too small for traditional market makers to service. To address this the crypto ecosystem developed Automated Market Makers (AMMs).

What is an AMM?

Unlike traditional market makers that rely on buy and sell orders to determine prices, Automated Market Makers (AMMs) utilize a mathematical formula to price assets automatically. By using liquidity pools instead of order books, AMMs enable decentralized trading by setting prices according to the current supply and demand within their pools, thus allowing for instant, peer-to-peer transactions without direct counterparties. This innovative approach not only can improve the trading experience but it also democratizes market making, making it so anyone can provide liquidity and collect yield. Since AMMs utilize mathematical formulas they can be spun up on any asset at any scale allowing them to service most tokens in DeFi. 

How do AMMs work?

To provide liquidity in an AMM, a user deposits a pair of tokens into a liquidity pool, typically in equal value, and in return, receives liquidity tokens representing their share of the pool. This enables the AMM to offer trades between the deposited assets, with prices determined by a formula based on the pool's supply and demand. The pool charges fees which are distributed to the liquidity providers in terms of yield. The more volume through the pool and the higher the fee charged the more liquidity providers get paid.

AMMs are not risk free yield. As the prices of assets within a pool diverge due to market fluctuations, the AMM will rebalance the pool to maintain the predetermined ratio of assets. Rebalancing can be done dynamically by the pool or through arbitrageurs. This rebalancing act leads to what's known as impermanent loss for liquidity providers. It occurs because the value of their deposited assets changes in relation to one another; specifically, they end up holding more of the depreciated asset and less of the appreciated one due to rebalancing. This divergence from the original value can result in a loss relative to the potential gains had the assets been held outside the pool. The further prices diverge from the prices at which assets were deposited into the pool the more impermanent loss a liquidity provider will experience.

In the realm of DeFi, selecting pairs with stable assets is essential for liquidity providers (LPs) to minimize impermanent loss. For example, consider an LP contributing to a SOL/USDC pool when 1 SOL equals 100 USDC, depositing 1 SOL and 100 USDC. If the price of SOL doubles to 200 USDC, the AMM's mechanism adjusts the pool to maintain balance, resulting in the LP owning a mix that equates to less value than simply holding 1 SOL and 100 USDC outside the pool. The difference is impermanent loss.

CLMMs

Concentrated Liquidity Market Makers (CLMMs) are an evolution of the traditional AMM model, allowing liquidity providers to allocate their capital to specific price ranges within a liquidity pool, rather than dispersing it across the entire price curve. This mechanism concentrates liquidity where it's most needed, enhancing capital efficiency and potentially offering higher yields for provided liquidity within those ranges. Unlike AMMs, where assets are uniformly distributed, CLMMs enable providers to select ranges to target liquidity, improving capital efficiency by allowing providers to provide more depth with less capital within the range. This can allow for higher fee generation if the price of the asset stays within the selected range. However, this approach also introduces the risk of becoming temporarily inactive if the market price moves outside the selected range, potentially reducing earnings.

Concentrated Liquidity Market Makers (CLMMs) offer a nuanced approach to limit impermanent loss through the strategic allocation of capital within predetermined price intervals. Since CLMMs concentrate liquidity provision within certain intervals CLMMs limit the exposure of LPs' capital to broader market price movements outside their chosen intervals. Within the chosen interval impermanent loss is higher given the concentration of liquidity. If the asset price moves beyond these ranges, the capital is no longer at risk of impermanent loss associated with those out-of-range movements because it's not actively providing liquidity in those price levels. This focused participation inherently reduces the likelihood of substantial impermanent loss, as the assets are less exposed to volatile price swings, making CLMMs an effective tool for LPs looking to mitigate this risk while still capitalizing on their market insights.

Considerations 

To maximize profits, liquidity providers (LPs) try to strategically select pools that combine high trading volumes, high fees and stable asset pairings to maximize yield while avoiding impermanent loss. This section will explore considerations liquidity providers can implement to avoid impermanent loss.

Liquidity Mining

Liquidity mining is the process of protocols emitting tokens to encourage, or “mine”, users to use their protocol or provide liquidity. In the context of liquidity provision, liquidity mining is done to either encourage liquidity for a protocol's native token or by a platform to attract liquidity providers to use it. These rewards, often in the form of the platform's native tokens, serve as an incentive to attract and retain liquidity providers, effectively increasing the pool's capital and trading volume. This strategy not only compensates for the inherent risks associated with AMMs, such as impermanent loss, but can also significantly augment the total yield for liquidity providers. 

Hedging

To counteract impermanent loss exposure in DeFi, liquidity providers (LPs) can employ derivatives as a strategic hedge. Continuing with the SOL/USDC pool example, suppose an LP deposits 1 SOL (valued at 100 USDC) and 100 USDC. To hedge against potential impermanent loss, the LP could take a long position in a SOL derivative contract equivalent to the deposited SOL value. If SOL's price then escalates to 200 USDC, the LP's gain on the long position would more than offset the impermanent loss experienced within the AMM pool. This derivative strategy effectively provides a financial cushion, allowing the LP to maintain the overall value of their investment despite fluctuations in SOL's price. 

The hedging example provided the derivatives are used to mitigate impermanent loss in a scenario where SOL's price increases. While this strategy offers protection against losses due to an increase in the SOL price, comprehensive hedging strategies can also be crafted to protect against both upward and downward movements with strategies like straddles or strangles. Hedging strategies only make sense when the total yield (or return) from participating in the liquidity pool outweighs the costs associated with the hedging positions. This includes both options premiums and funding rates. If the cost of the hedge significantly erodes the potential earnings from the liquidity pool, the strategy may not be financially viable. 

Diversification

Liquidity Providers (LPs) can utilize multi-pool strategies to limit impermanent loss by diversifying their investments across multiple liquidity pools, each with varying asset pairs and risk profiles. This approach spreads the potential risk of impermanent loss across different markets and conditions, reducing the impact of significant price movements in any single asset. For example a LP might allocate capital to pools containing uncorrelated assets like $MOBILE/USDC and $JUP/USDC to reduce exposure to significant price changes in any one asset. By strategically selecting pools with assets that have non-correlated or inversely correlated price movements, LPs can reduce the likelihood that a significant price movement in one asset will adversely affect their entire portfolio. This multifaceted approach allows LPs to tailor their risk exposure and optimize their potential returns, leveraging the dynamics of different pools to balance out impermanent loss against profit opportunities.

Delta Neutral

Liquidity Providers (LPs) can craft a delta-neutral yield position by deploying capital into liquidity pools containing correlated assets. This strategy involves selecting asset pairs that move in tandem or have a strong correlation, such as different liquid staking token pools like $LST/$SOL. By providing liquidity to a pool of correlated assets, an LP can essentially offset the price movement of one asset with the other, maintaining a balanced position irrespective of market fluctuations. This delta-neutral position mitigates the potential for impermanent loss since the relative value of the assets remains more constant, allowing LPs to capitalize on the yield generated from trading fees while maintaining full exposure to assets in the pool. 

Tools and Protocols

The DeFi landscape is continuously evolving, introducing innovative tools and platforms designed to enhance the liquidity provision experience. Among these advancements, automated strategies and rebalancing tools stand out, offering liquidity providers (LPs) sophisticated mechanisms to manage and optimize their positions with minimal manual intervention.

Auto Rebalancing Pools

Auto rebalancing pools present a novel approach in decentralized finance (DeFi) that addresses some key limitations of traditional Automated Market Makers (AMMs). By automatically adjusting their parameters to maintain tighter price spreads around the market value, these pools significantly reduce the risk of impermanent loss for liquidity providers (LPs) by minimizing the price divergence of assets within the pool. This innovative mechanism lessens the pool's dependence on arbitrageurs for price correction, thereby preserving more liquidity within the pool and preventing value extraction by arbitrage profits. Furthermore, auto rebalancing pools deploy dynamic fee structures and reward mechanisms that align more closely with current market conditions, offering LPs potentially better compensation for their provided liquidity compared to the static fees of traditional pools. The entire rebalancing process is managed through smart contracts, eliminating the need for manual intervention by LPs and reducing the risk of losses due to delayed reactions to market movements. This automated management ensures a more efficient and time-saving operation, contributing to the overall effectiveness and appeal of auto rebalancing pools in the DeFi ecosystem.

Drifting CLMMs

Protocols like Kamino offer auto rebalancing CLMM where the ranges drift over time. The benefit of drifting CLMMs is that you maintain the capital efficiency benefits of a CLMM while minimizing time in which capital isn’t active by moving the range to adjust to price. Ranges can be adjusted a number of different ways, one of the ways is setting them based on a drifting strategy.  Usually ranges are set based on a moving average but there are multiple different ways to set ranges depending on goals of LPs. The idea of using a moving average to set range is that most of the time the price will be in range keeping the liquidity pool active, but if there is a sharp price change in either direction the pool will become as price moves outside of the range helping protect liquidity providers against impairment loss. Drifting CLMMs are a good way to passively maximize capital efficiency while protecting against impermanent loss. 

Other adjacent products

In addition to traditional liquidity provision on AMMs, sophisticated methods like the Jupiter Liquidity Provider Pool (JLP), Drift Market Making Vault, and Drift Insurance Fund offer alternative avenues for liquidity providers to earn yield. The JLP allows users to deposit assets to receive non-rebasing JLP tokens, sharing in 70% of trading fees as yield. This allows users to passively provide liquidity and get exposure to jupiter. The Drift Market Making Vault employs a delta-neutral strategy in perpetual swaps, rewarding users with a portion of the profits generated, despite facing volatility and counterparty risks. Lastly, the Drift Insurance Fund offers stakers hourly rewards from a Revenue Pool funded by fees from various protocol activities, with a unique mechanism to handle levered losses and AMM deficits. Each option presents a different risk-reward profile and mechanism for yield generation, catering to users with varying risk appetites and liquidity provision strategies. Each of these have their own benefits and unique risk but tools like these are valuable in building your ideal portfolio. 

Disclaimer: None of the content in this article should be construed as financial advise. It is for information purposes only. Always do you own research.

Resources:

AMM: https://chain.link/education-hub/what-is-an-automated-market-maker-amm 

Impermanent loss: https://www.techopedia.com/definition/impermanent-loss 

CLMMs: https://droomdroom.com/concentrated-liquidity-market-maker-explained/ 

Protocols: 

Drift: https://app.drift.trade/earn/mm-vaults 

Kamino: https://app.kamino.finance/liquidity?filter=all&sort=tvl 

Jupiter: https://jup.ag/perps-earn