Binance Liquidity Swap explained: the ELI5 way
If you're anything like me, you've looked at ways to get some passive gains with your crypto and came across Binance Liquidity Swap. Intrigued and some Google Fu later you're left in the awkward spot of thinking you understand the rough concept, but don't actually understand it well enough to explain in simple terms.
While I wouldn't claim I'm a master at grasping the concept, I feel I'm confident enough that I managed to simplify it enough to the point it actually makes sense. And seeing as how I never encountered a resource that managed to explain it super simple, I figured I may as well share my thoughts in the hopes of helping others. So, here's what I got out of it:
The funny part is, the concept is actually incredibly simple and should be VERY familiar to you already. The quick and dirty is this: when participating in a liquidity swap, you're basically automatically taking profits and/or buying dips. This is the single most important part to grasp, as this is basically THE risk/catch and the source for most of the confusion.
Let's take the most familiar example: BTC/USD. Before you comment: yes, I know Binance doesn't actually offer this pair, but it's the easiest way to explain the concept, so bear with me.
Before we dive in further, let's quickly go over the basics. If we put 100 USD worth of tokens in a BTC/USD liquidity swap, we effectively get 2 bags: 50% is used for BTC and 50% for USD. If we assume 1 BTC is 50 USD, we now have 1 BTC and 50 USD in our swap portfolio. Now, whenever the price moves, so will the number of tokens you hold. The reason is simple: the market always strives for perfect balance, so it wants 50% in BTC and 50% in USD. So, if the price of BTC doubled, the market automatically sells enough BTC to get a 50/50 split.
Let's do the math here and you'll start to understand what happens.
* Portfolio start: 1 BTC (worth 50 USD) & 50 USD. Total worth: 100 USD. * BTC price doubles to 100 USD. Portfolio is now: 1 BTC (worth 100 USD) & 50 USD. Total worth: 150 USD. * System rebalances our portfolio to a 50/50 split. 150 divided by 2 = 75 USD for each token. * New portfolio: 0.75 BTC (worth 75 USD) and 75 USD. Total worth: 150 USD.
The good news: your portfolio is worth 50% more! The perceptive among you will notice that's precisely half of the price movement (100% gain over 50% of your portfolio after all). So what's the catch? Well, if you used that full 100 USD on bitcoin and just HODLed, you would have 2 BTC worth 200 USD. This effect is magnified the more fluctations there are.
For example, if the price increased five times by 10 USD each time (instead of 50 USD in 1 go), the numbers are as follows (HODL value simply multiplies the current price by 2 BTC):
* Portfolio start; BTC = 50 USD: 1 BTC & 50 USD. Total value: 100 USD. HODL value: 100 USD. * BTC = 60 USD. Portfolio: \~0.92 BTC & 55 USD. Total value: 110 USD. HODL value: 120 USD (+10). * BTC = 70 USD. Portfolio: \~0.85 BTC & \~59.58 USD. Total value: 119.17 USD. HODL VALUE: 140 USD (+20.83). * BTC = 80 USD. Portfolio: \~0.8 BTC & 63.84 USD. Total value: 127.68 USD. HODL VALUE: 160 USD (+32.32). * BTC = 90 USD. Portfolio: \~0.75 BTC & 67.83 USD. Total value: 135.66 USD. HODL VALUE: 180 USD (+44.34). * BTC = 100 USD. Portfolio: \~0.72 BTC & 71.60 USD. Total value: 143.20 USD. HODL VALUE: 200 USD (+56.80).
As you can see, despite the same final price, our portfolio is actually worth less when it took more steps. So why even bother with liquidity swaps? Well, just as you take 50% less profit, you also take 50% less on losses. In fact, the more price moves back and forth, the more advantageous it is to liquidity swaps.
However, price changes aren't the only form of income. Liquidity swaps also give you passive income through swap fees. The more trading volume there is, the better your fee income. The income from fees can thus compensate your losses/limited gains. Keep in mind that the fee % is different for every pairing, so not all pairs are created equally.
So to quickly summarize: the main advantage of Liquidity Swap is that you're betting on 2 horses instead of just 1. This way you are only ever 50% exposed to price movements: a 50% gain would only net you 25%, but a 50% loss will only cost you 25%. This is an advantage during price drops and a small nuisance during price gains. At the same time, Liquidity Swaps are at their best with pairings where price moves back and forth constantly: not only will you constantly increase your position by buying & selling, but the trading volume will net you good returns through fees as well (provided the fee % is good).
The advantages:
* Passive income through fees (based on trading volume) * Limited exposure to losses * Great for pairings where price moves back and forth often
The disadvantages:
* Limited exposure to price gains * Not great for pairings where price hardly moves