Liquidity Provision - how does it work?

Heyo stormers! ✌️

As you already know, the biggest event of recent days was the launch of Storm Trade on Mainnet. Once again we congratulate everyone on this momentous occasion and remind you that there is now an Eye of the Storm rewards programme for early users, details of which can be found here.

With the transition to Mainnet, 3 trading pairs became available to users, as well as the possibility of providing liquidity, the mechanics of which raised many questions from the community.

In this article we offer you to understand together how this mechanics works, where liquidity is directed and what risks are involved in providing liquidity on Storm Trade.

What is liquidity provision? 🤔

Liquidity Provision is a way of generating passive income whereby a liquidity provider transfers its assets to a pool where those assets are utilised by the protocol.

In exchange for the use of liquidity, the exchange rewards the providers with a portion of its revenue generated from transactions executed in the protocol.

Speaking of Storm Trade, liquidity provision is one of the most important factors in the healthy existence of an exchange.

Where is the liquidity provided stored? 💰

To store liquidity safely and efficiently, Storm Trade has developed a special smart contract called Vault.

Who uses the provided liquidity? 🤝

To understand exactly how liquidity is allocated, let's turn to a diagram visualising the flow of funds between traders, stakers and providers (Figure 1).

Fig. 1 - Scheme of funds flow within the Storm Trade protocol
Fig. 1 - Scheme of funds flow within the Storm Trade protocol
Symbols of the scheme
Symbols of the scheme

Consider the person who provides liquidity to the Storm [jUSDT LP] protocol. Its funds are sent to the jUSDT Vault, which is designed to collect and store liquidity.

The movement of funds into the vault is directly dependent on the state of trading taking place on the Storm exchange. By trading, traders open and close positions, pay trading fees, and their funds may be subject to liquidation. From all these actions liquidity providers receive income.

Let's imagine that a trader has opened a long position of 1,000 jUSDT with x3 leverage in the BTC/USDT pair. The collateral for the trader's position is immediately sent to Vault. The price of BTC has risen by 5%, the trader rejoices in his prowess. By paying 0.12% (of open interest) to open and close the position, as well as 10 jUSDT of Funding and 1 jUSDT Rollover Fee, the trader received a positive PnL of 126.7 jUSDT.

Having earned a profit, the trader should receive the sum of his collateral and positive PnL from the vault. The collateral that the trader deposited is returned to him from the liquidity vault, but where does the payment of the positive PnL come from? Right, also from the vault, where there is a stock of liquidity from the providers who provided it there.

Let's consider the opposite situation. The price of BTC has fallen by 5%, the trader is upset and is going to close the position at a loss. After paying of 0.12% fees to open and close the position, 10 jUSDT of Funding and 1 jUSDT of Rollover Fee, the trader pays a negative PnL of 173.7 jUSDT.

The loss paid by the trader is deducted from the collateral for his position and sent to the Vault as a reward for liquidity providers.

Motivation ⭐️

If liquidity providers received only negative PnL positions of traders, the funds would be evenly distributed and there would be no point for providers to take the risk of making their funds available for trading. This is why the Storm protocol calculates additional motivational incentives for liquidity providers.

By risking "impermanent losses" subject to temporary "gains" of traders, in addition to negative PnL, liquidity providers are rewarded with:

  • 70% of all protocol trading fees;

  • 35% of liquidation penalties;

  • RP rewards under Eye of the Storm;

  • 70% of funding paid by traders.

As the market is often quite unpredictable and volatile, we refer to the examples below for an idea of the allocation between traders and liquidity providers.

Let's consider 3 situations that can happen:

  • traders are trading at 0 in total, i.e. the number of traders' profits is approximately equal to the number of losses. In this case liquidity providers stay with their deposits and are rewarded with 70% of trading fees and funding, 35% of liquidation penalties and RP rewards.

  • traders are trading in minus, i.e. the number of traders' losses exceeds the number of profits. In this case liquidity providers stay with their deposit and receive all the above mentioned rewards in combination with traders' negative PnL.

  • traders are trading in plus, i.e. the number of traders' profits exceeds the number of traders' losses. In this case, liquidity providers incur impermanent losses but continue to mitigate risk by receiving rewards in the form of 70% of trading fees and fundings, 35% of liquidation penalties and RP as additional rewards.

Why liquidity provision is not staking? 👀

The staking function will be available when the Storm token becomes available, i.e. after the TGE (token generation event).

Staking and liquidity provisioning mechanisms have completely different internal logic. While staking guarantees you a positive income without using the tokens in trading, the liquidity provided is sent to the "vortex" of trading, which can end in a profit or a loss for the trader.

Storm token stakers will receive a smaller share of trading fees (30%) because the staking process does not involve the risks of trading volatility and volatile losses (Figure 1).

Impermanent losses and the current SLP rate 📈

The interval of time when traders are cumulatively "in the plus", while providers meanwhile "pay for the banquet", we call impermanent losses.

Impermanent loss is a short-lived phenomenon where, due to the payment of positive PnL to traders, a liquidity drawdown forms in the vault and the liquidity providers' rewards go into negative values.

Let's introduce a new concept that has not been mentioned before - SLP. SLP is a Storm LP token that indicates the ratio of the amount of funds earned by liquidity providers to the amount of liquidity provided by them in jUSDT.

If SLP is 1, it means that liquidity providers' earnings are equal to traders' earnings. If SLP >1, the providers are earning, and if <1, they are losing. For visual convenience, the SLP rate can always be observed on a chart (Fig. 2).

Fig. 2 - graph of SLP dependence on time for a month
Fig. 2 - graph of SLP dependence on time for a month

The time at which suppliers bring in liquidity is also an important profit driver. Let's turn to the chart below (Fig. 3).

Fig. 3 - graph of SLP dependence on time for a week
Fig. 3 - graph of SLP dependence on time for a week

In Fig. 3 we can see how the SLP changed over a week of trading on the Storm protocol. By observing the current SLP, providers can choose the optimal time to provide liquidity.

Example 1. Users who provided liquidity on 29 October (Fig. 3.1) were in the time period with the maximum SLP rate, when traders were trading in minus. After 29 October the situation changed and traders started to actively make profit. Thus, those who provided liquidity, gave part of it to pay profit to traders, while they themselves incurred impermanent losses.

Fig. 3.1 - graph of SLP dependence on time for a week
Fig. 3.1 - graph of SLP dependence on time for a week

Example 2. Users who provided liquidity on 31 October (Fig. 3.2) fell into a liquidity hole with a low SLP rate, after which traders incurred losses, SLP started to rise, and liquidity providers remained in the plus side.

Fig. 3.2 - graph of SLP dependence on time for a week
Fig. 3.2 - graph of SLP dependence on time for a week

By observing the examples above, we can see how the timing of liquidity delivery affects the profit or loss of suppliers.

While the trader is getting a positive PnL in the moment, the liquidity supply is working away. We're just getting started, right?

Fig. 4 - graph of SLP dependence on time since the opening of trading
Fig. 4 - graph of SLP dependence on time since the opening of trading

Providing liquidity - benefit over distance 💎

Here are some statistics. In the chart below (Fig. 5), we see the change in PnL of gTrade traders over 2022-2023. The blue straight lines show the daily change in PnL, while the red broken line shows the cumulative change in PnL. This chart shows that by April 2023, traders have cumulatively lost more than USD 5mn, which is however only -5% of position collateral.

This distribution proves that liquidity providers win over longer time frames.

Probability theory does not deceive, it is always on the side of truth.

Figure 5 - change in PnL of gTrade traders over the 2022-2023 period
Figure 5 - change in PnL of gTrade traders over the 2022-2023 period

Conclusion ✍️

Having told you about the concept of liquidity provision, its pros and cons, differences from staking, we hope that we have helped you to understand how this mechanism works. Don't forget about risk management, trade with amounts you are not afraid to lose, provide liquidity wisely and enjoy the balanced product we try to create.

Thank you for reading. Always your Storm team!

Join our community and be the first to know the news 👇

Super-Chat | Website | News | Twitter

More info about Storm Trade 👇

Articles | Roadmap | Documentation

Subscribe to Storm Trade
Receive the latest updates directly to your inbox.
Mint this entry as an NFT to add it to your collection.
This entry has been permanently stored onchain and signed by its creator.