Hi, Tsunami Community!
After the launch of liquidity provision we faced a lot of questions about how this mechanics works, where liquidity is directed and what are the risks associated with providing liquidity on Tsunami Exchange.
In this article, we will tell you about the concept of liquidity provision, its fundamental differences from staking and try to dispel the clouds of misunderstanding on the way to clarity.
Liquidity Provision is a way of generating passive income, which implies the transfer of liquidity provider's assets to a pool, where these assets will be used by the protocol for certain purposes.
In exchange for the use of liquidity, the exchange rewards the providers with part of its profits, obtained during the operations of the protocol.
Speaking of DEX or perpetual futures, liquidity provision is one of the most important factors in an exchange's healthy existence.
With the launch of the updated Tsunami 2.0 protocol, the AMM is no longer independent of the trader's path, and the trader's gains may not equal his losses. Thus, the system requires makers (liquidity providers or LPs).
In order to store liquidity safely and efficiently, a special vault called Omnivault was introduced at Tsunami Exchange. This vault aggregates liquidity from all markets and directs it to staking protocols, increasing the passive income of liquidity providers.
To understand exactly how liquidity is moved inside the protocol, let us refer to the diagram clearly demonstrating the flow of funds between traders, stakers and liquidity providers (Fig. 1).
Let’s look at Fig.1 and consider the man who provides liquidity to the Tsunami protocol [XTN LP]. His funds are sent to Omnivault, designed to collect and store liquidity.
The movement of funds in the vault is directly dependent on the state of trading taking place on the Tsunami Exchange. While trading, traders open and close positions, pay trading fees and their funds may be subject to liquidation. Liquidity providers earn income from all these actions.
Let's imagine that trader Alex opened a long position of 1,000 XTN with x3 leverage in the BTC/XTN pair. The price of BTC has risen by 5%, Alex is happy with his trading skill. After paying 0.2% (on open interest) to open and close the position as well as 10 XTN Funding and 1 XTN Rollover Fee, Alex received a positive PnL of 126.7 XTN.
Having earned a profit, the trader must receive from the protocol the amount of his collateral and positive PnL. The deposit Alex made is returned to his wallet from the liquidity pool, but where does the payment of positive PnL come from? Right, also from the vault, where there is a supply of liquidity from the providers who have provided it there.
Consider the opposite situation. BTC has fallen 5%, Alex is very upset and is about to close the position at a loss. After paying 0.2% (on open interest) to open and close the position, 10 XTN Funding and 1 XTN Rollover Fee, Alex pays a negative PnL of 173.7 XTN.
The loss paid by Alex is deducted from his position collateral and sent to Omnivault as a reward for liquidity providers.
If liquidity providers only received negative PnL positions from traders, the funds would be evenly distributed, and it would not make sense for providers to take the risk of providing their funds for trading. That's why the Tsunami Protocol enters additional motivational incentives for liquidity providers.
At the risk of incurring "impermanent losses" subject to traders' temporary gains for some time, in addition to negative PnL liquidity providers are rewarded with:
70% of all protocol trading fees;
50% of liquidation penalties;
additional rewards from the Tsunami Marketing Fund of 600 TSN per week;
additional profits from staking a part liquidity on protocols within the Waves ecosystem.
Since the market is often quite unpredictable and volatile, let's look at the examples below to get an idea of the allocation of funds between traders and liquidity providers.
Traders trade at 0, 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 600 TSN per week as additional reward.
Traders trade in minus, i.e. the number of traders' losses exceeds the number of profits. In this case, liquidity providers remain with their deposit and receive all of the above rewards in the form of 70% of trading fees, 50% of all liquidation penalties, and 600 TSN per week as additional reward.
Traders trade in the aggregate in the positive, i.e. the number of traders' profits exceeds the number of losses. In this case, liquidity providers incur impermanent losses, but continue to compensate by receiving rewards in the form of 70% of trading fees and 600 TSN per week as additional reward.
Here it is worth specifying that based on the results of the first week after the launch of trading, it was decided to increase trading fees in pairs with the XTN token to reduce the risks of providing liquidity. You can read more about the changes in our recent post.
Staking and liquidity provision mechanisms have very different internal logic. Whereas staking guarantees you a positive income by not using staked tokens in trading, the liquidity provided is sent to the trading itself, which can end in both profit and loss for the trader.
For the same reason, when you stake TSN tokens, you can return them at any time, but the liquidity you provide cannot be returned instantly so as not to disrupt the logic of the trade and create a liquidity drawdown.
TSN stakers receive a smaller share of trading fees (30%) because the process of staking does not involve the risks of trading volatility. However, stakers have the advantage of receiving a share of trading fees in both XTN and USDT tokens in the future (Fig. 1).
The interval of time when traders are summarily "in the black" while LPs are "paying the banquet" we call impermanent losses.
Impermanent losses are short-lived phenomena, when due to the payment of positive PnL to the traders a liquidity hole is formed in the vault and the liquidity providers' rewards earned go into negative values.
Let us introduce a new concept not mentioned before - rate. Rate is a ratio between the amount of liquidity and the amount of funds paid out to traders.
If the rate is equal to 1, this means that liquidity providers' earnings are equal to traders' earnings. If the raiting is >1, LPs earn, and if <1, they lose. We are thinking that it would be more convenient for providers to see the current rate on the liquidity provision page, but the team is still looking for a better option.
The time at which LPs deposit liquidity is also an important factor in profits. Let's turn to the chart below (Fig. 2).
In Fig. 2 we can see how the rate has changed since the opening of trading on Protocol 2.0 in 2 days. By observing the current rate, LPs can choose the best time to provide liquidity.
Example 1. Users who provided liquidity from 12:00 02/08 to 6:00 02/09 got in time interval with maximal rate, when traders together were trading in minus. After 8:00 02/09 the situation has changed and traders began to actively gain profit. Thus, those who provided liquidity gave a part of their profit to the traders, while they incurred impermanent losses.
Example 2. Users who provided liquidity at 8:00 02/09 got into a liquidity pit with low rate, after which traders incurred losses, the rate began to grow and liquidity providers remained in profit.
While the trader gets a positive PnL in the moment, liquidity supply works on the distance.
Liquidity provision ensures the efficient economics of the protocol. This method is the most common among the giants of the futures trading industry and has proven itself as a revenue method for liquidity providers and traders alike.
Having told you about the concept of liquidity provision, its pros and cons and the difference from staking, we hope that we have helped you to understand how this mechanism works. Don't forget about risk management, trade with sums you are not afraid of losing, provide liquidity wisely and enjoy a balanced product we try to create.
Thank you for reading.
Always your Tsunami Team!