Liquidity Providers are essential to decentralized prediction markets. Before forecasters can buy and sell outcome shares in a prediction market, markets are required to have liquidity.
The benefits of adding liquidity to markets powered by Polkamarkets are the following:
Liquidity Providers receive a fee from every buy/sell transaction. By default, the fee is set to 2% (developers who are deploying the Polkamarkets smart contract themselves can set this fee to any amount they like).
The more liquidity is added to a market, the lesser the price impact when buying or selling outcome tokens, and the more accurate is the forecast.
There is, however, a risk of near-total loss for liquidity providers that must be well understood before adding liquidity to a market.
Make sure you read through the following sections and understand the risks and that strategies to adopt to increase the likelihood of being a profitable liquidity provider.
You’re welcome to join the Polkamarkets community on Discord to ask questions and debate strategies.
Introduction to the liquidity mechanism
The Polkamarkets Protocol uses an Automated Market Maker (AMM) system adapted to the Prediction Markets use case. As with other AMM-powered systems, such as Uniswap or other DEXes, liquidity providers who use the Polkamarkets Protocol must have strategies to deal with the risk of loss.
Importantly, due to the zero-sum nature of prediction markets, the risk is greater than that incurred with other AMMs, as you’re risking near-total loss, rather than impermanent loss.
At the moment of market creation, the initial liquidity provider’s stake is converted to liquidity shares. The liquidity provider receives 100% of all liquidity shares. At that moment, the price of both outcomes is even (0.5 and 0.5). The initial liquidity provider does not receive any outcome shares when adding liquidity but, when removing liquidity, they will receive a portion of their stake as shares of the least likely outcome (the outcome with the lowest price).
After a market has been created, and some trades have already happened, any new liquidity provider adding liquidity to the market will receive a portion of their stake in liquidity shares, and another portion in shares of the most probable outcome at that moment (ie. the outcome with the highest price). When removing liquidity, they’ll receive a portion of their stake back as shares of the least likely outcome.
Make sure to read our article about how outcome prices are determined if you’re not familiar with the Automated Market Maker mechanism used by Polkamarkets.
Profitability through volume
For liquidity provisioning to be profitable, the market must have several times more trading volume than it has liquidity. The more buy and sell transactions happen on the market, the more fees are collected by the liquidity providers.
Market creators and liquidity providers should carefully consider whether a given market is likely to be of interest to a high enough number of forecasters, who will generate enough trade volume. They can also actively promote the markets they participate in to attract more forecasters who will contribute with more transactions.
The following graph shows the return on investment (ROI) of liquidity providing given different trading volume scenarios. The data assumes that:
liquidity is provided at the time of market creation, when the outcome prices will be even (0.5 for outcome A and 0.5 for outcome B)
the fee awarded to liquidity provider is 2%
In other words, at the two extremes:
If the final price of the winning outcome is 0.5, the liquidity provider will always take a 2%, as long as the trading volume is at least identical to the amount liquidity added to the market. For example, if there were 5 MOVR in liquidity, the trading volume must be at least 5 MOVR.
If the price of the winning outcome is 0.99, the initial liquidity provider will only reach break-even (0.05%) if the trading volume in the market is 45x greater than the market liquidity. For example, if there were 5 MOVR in liquidity, the trading volume must be at least 225 MOVR.
These extreme cases are super rare on Polkamarkets. The average and median closing prices of the most likely outcome tend to be comprised between 0.6 and 0.8 in markets across all categories. The exception seems to be for markets in the Crypto category, where the average closing price of the most likely outcome has been 0.89, and the median price 0.92, as of April 2022.
While the relationship between total volume and total liquidity is always true, the exact volume/liquidity ratio required for profitability will depend on the price of the outcomes at the moment when liquidity was added.
The example above assumes that liquidity was added at market creation, when the price of both outcomes is even. The ratio becomes less demanding if liquidity is added when outcome prices are closer to the closing prices.
For instance, if a liquidity provider adds liquidity when the outcome prices are at 0.6 and 0.4, and the final price is 0.7 and 0.3, they'd need a 3x volume to liquidity ratio to break even, rather than the extreme 45x.
It's important to underline that whatever the ratio is at the moment that you add liquidity, it is that ratio that will apply all the way. If more people add liquidity, and the amount of liquidity goes up, the target volume also increases -- the ratio will stay the same.
Also note that if the fee is higher, the volume-to-liquidity ratio required to achieve profitability is smaller as well. For example, if the fee is set to 5% instead of 2%, the ratio of the extreme case where the most likely outcome is 0.99 is reduced to 18x, instead of 45x. Setting a higher fee benefits the liquidity providers, but of course hurts forecasters.
Risk hedging through active liquidity management
In addition to ensuring that they're adding liquidity to high-volume markets, liquidity providers can embrace an active approach to risk hedging, which requires monitoring the evolution of outcome prices, actively adding or removing liquidity depending on the price changes, and even buying outcome shares to limit their exposure to price swings which can negatively impact their earnings.