Why Is High APR Killing Your Gains While LPing?
Liquidity providers (LPs) are the backbone of DeFi, supplying the essential liquidity for trading and earning fees from swaps. While APR is a key metric for LPs, focusing solely on high APR can be misleading and potentially costly. Let’s delve into why LPs should look beyond APR and consider overall profitability.
Understanding Liquidity Pools
LPs can choose between two main options for deploying their liquidity: V2 pools or V3 concentrated liquidity pools.
1. V2 Pools
In V2 pools, assets are deposited in a ‘full range’ from 0 to ∞, covering every price point where they can be traded.
• Set and Forget: Once you deposit, it’s on autopilot
• Constant Asset Ratio: The assets are always in a 50:50 ratio
• Uniform APR: The APR is the same for all participants
2. V3 ‘Concentrated Liquidity’ Pools
V3 pools allow users to concentrate liquidity in specific price ranges.
• Customizable Price Ranges: Liquidity can be provided within specific price bands
• Dynamic Asset Ratios: The asset ratio changes with price movements
• Active Management: Positions generate fees only if they cover the current price, requiring active position management
• Variable APR: The narrower the range, the higher the share of generated fees, but also the higher the susceptibility to impermanent loss (IL)
V3 Ranges: Narrow vs. Wide
1. Narrow Ranges
• High Fee Generation: Generate more fees due to concentrated liquidity
• Constant Monitoring: Require frequent rebalancing to stay within the active range
• High Impermanent Loss: Heavily exposed to rapid price movements and IL
2. Wide Ranges
• Lower Fee Generation: Generate fewer fees as liquidity is spread out
• Less Frequent Rebalancing: Require less manual intervention
• Reduced Impermanent Loss: Less affected by price movements
How Impermanent Loss (IL) Affects LPs
Impermanent loss is the difference in value between deposited and withdrawn assets from the pool. The bigger the price difference, the bigger the loss.
Example
BRO deposits $6,000 in total — 50:50 1 ETH + 3,000 USDC into a pool and the pool now holds 10 ETH + 30,000 USDC and BRO holds 10% of the pool. If the price of ETH increases to 6,000 USDC, arbitrageurs rebalance the pool so the ratio reflects the price = 7.1 ETH + 42,500 USDC (according to the X*Y=K formula)
If BRO withdraws his 10%, he gets 0.71 ETH + 4,250 USDC = ~8,500 USDC, which is a decent profit.
But what if he held that 1 ETH + 3,000 USDC? Then he would have 6,000 USDC + 3,000 USDC = 9,000 USDC, 500 USDC more. Impermanent loss is the $ difference between the withdrawn value from the pool and just holding the tokens (HODL).
HODL says how much you make by just holding the coins 50:50. This is used as a benchmark because it says if LPing (or any other form of investing) is better than passive token holding.
High APR ≠ Best
Many LPs rely on APR, trying to maximize the fee generation. However, that doesn’t represent the actual “profit” which depends on:
1. APR: A superficial metric, especially in V3 pools
2. Price Movement: Directly impacts asset ratios and IL
(3. Liquidity Incentives: Additional rewards from protocols)
Maximizing APR in narrow ranges often means maximizing IL. Fees need to outweigh the price movement to be profitable, and that’s rarely the case.
Practical Example: APR vs. Actual Returns
We’re running two ETH/USDC strategies: one focusing on high APR, the other more passive.
Performance period 20/1/24–19/7/24, HODL growth 21%
• High APR = +10% growth, vs. HODL = -11%, APR = 150–200%
• Passive = +22.5% growth, vs. HODL = +1.5%, APR = 1–10%
In 6 months, the ‘Passive’ strategy with a much lower APR outperformed the ‘High APR’ strategy by more than 12% on the net results.
The Brokkr Way: Performance & Transparency
At Brokkr, we prioritize real returns after IL, not just APR. We benchmark all strategies to HODL and run thorough backtests to ensure transparency, giving LPs confidence to provide liquidity. If you can’t beat HODL, why LP?
Many LPs are unaware of their actual performance. Most DEXs and ALMs display only APR, not results after IL. LPs often need third-party tools like Revert to check the actual performance.
It’s easy to generate 300%+ APR in a narrow range, but is it profitable? Hell no. The generated fees can’t keep up with the losses generated by the price movement and rebalancing costs. It can work well in short periods, but it’s not suited for long term deposits.
What Should LPs Do?
You must find the balance between the generated fees and the price movement because it heavily affects the returns. By prioritizing APR it is difficult to beat impermanent loss and other factors influencing profitability like LVR. Loads of LPs and ALMs (automated liquidity managers) found the hard way that it is not that simple.
• Active Management: Rebalance positions frequently to stay within profitable price ranges and rebalance before you get out of range. Use your market expectations to set the ranges
• Cautious Use of ALMs: Automated liquidity managers often struggle with beating IL and might not be as profitable as you might think
• Wider Ranges for Passive Yield: Wider ranges with lower APRs typically perform better and are less susceptible to volatility for long-term deposits. If you feel adventurous, go with narrower ranges but be prepared to monitor and rebalance the positions frequently.
• LPing In Correlated Pools: Correlated pools like USDT/USDC or weETH/wETH don’t suffer from impermanent loss and are much easier to maintain. Similarly, BTC/ETH is a pool where LPs are more profitable as the impermanent loss is not as substantial as in other pools, especially when paired with a stablecoin — eg. ETH/USDC.
Disclaimer: For simplicity's sake, we don’t go into details of LVR and other factors that influence LPs profitability.
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