Providing Liquidity
Last updated
Last updated
Liquidity providers capitalize Notional’s liquidity pools. They contribute currency and fCash to the liquidity pools and act as counterparty to the lenders and borrowers that are active on the protocol. In exchange for their contribution, liquidity providers earn fees every time a lender or borrower trades between currency and fCash.
To deposit currency into a liquidity pool, a liquidity provider first specifies a liquidity pool and the amount of cash they want to supply as liquidity. Then the liquidity provider mints a pair of fCash tokens.
The liquidity provider then deposits their cash and the positive fCash into the liquidity pool and receives liquidity tokens in return.
Now the liquidity provider has liquidity tokens and an obligation that is offset by the positive fCash that their liquidity tokens entitle them to.
When a liquidity provider provides currency to a liquidity pool, they receive liquidity tokens. Liquidity tokens represent their proportional claim on the currency and fCash tokens in that pool.
A liquidity provider can redeem liquidity tokens for these underlying assets at any time.
A liquidity provider's profit and loss (P&L) shows them the amount of money they have made or lost at any given time. A liquidity provider's P&L is calculated as the difference between their net current holdings and their initial deposit. At the time of initial deposit, a liquidity provider's P&L is 0 because their net current holdings equals their initial deposit.
But the liquidity provider’s P&L and net current holdings change when users start to make trades. Imagine that a lender sold Dai for Dec 1 2020 DAI and now the liquidity providers’s liquidity tokens are worth 105 Dai and 101 Dec 1 2020 DAI.
The liquidity provider now has a net fCash position. If they were to withdraw their liquidity now, they would hold an extra 5 Dai but would also be a net borrower of 4 Dai. The liquidity provider's P&L will depend on the Dai value of -4 Dec 1 2020 DAI. In other words, the liquidity provider's P&L depends on the exchange rate between Dai and Dec 1 2020 DAI.
Action
Pool Dai
Pool fDai
Exchange Rate
Interest Rate
LP fDai Position
LP P&L (Dai)
Provide
Liquidity
500,000
500,000
1.01
12.00%
0
0
Borrow
495,056
505,000
1.0102
12.28%
5,000
5
Lend
496,047
504,000
1.0102
12.22%
4,000
7
Lend
505,962
494,000
1.0097
11.66%
-6,000
19
Borrow
491,131
509,000
1.0104
12.51%
9,000
38
Borrow
486,188
514,000
1.0107
12.79%
14,000
40
Lend
510,975
489,000
1.0095
11.37%
-11,000
79
The returns to providing liquidity on Notional come from a combination of trading fees earned and changes in the value of a liquidity providers's net holdings.
Like other automated market makers (AMMs), returns on the Notional AMM are driven to a large extent by trading volume, total liquidity in the pool, and the fees charged on trading. The more trading that happens on a given liquidity pool means the greater the amount of fees accrue to liquidity providers.
The difference between the Notional AMM and other AMMs comes in the calculation of a liquidity provider's position P&L, or what is commonly known as impermanent loss. Impermanent loss refers to the loss incurred by liquidity providers when the market moves away from the exchange rate at which they provided liquidity: liquidity providers get shorter when prices go higher and longer when prices go lower. This concept applies to Notional liquidity providers as well. However, the effect is much smaller on Notional than it is for liquidity providers providing capital to an ETH/DAI liquidity pool because cash/fCash exchange rates are much less volatile than ETH/DAI exchange rates.
Impermanent loss on Notional comes with a twist. Cash/fCash exchange rates converge to 1 as fCash approaches maturity even in the absence of trading. This means that a liquidity provider with a net positive fCash position will consistently make money over time if nothing happens because the Dai value of their fCash will gradually increase. Conversely, a liquidity provider with a net negative fCash position will consistently lose money over time for the same reason.
This shouldn't be surprising. A net negative fCash position is equivalent to borrowing, and a net positive fCash position is equivalent to lending. The money that a liquidity provider earns or loses over time reflects the interest they are accruing or paying through their fCash holdings. This effect is known as interest rate carry, or carry. A net positive fCash position results in positive carry for a liquidity provider and a net negative fCash position results in negative carry.
