How Do Liquidity Pool Economics Work?

Question

I'm looking at liquidity pools (LPs), and the economics don't make sense given the APYs. How is this possible, or are exchanges simply taking a loss to establish market dominance? Please tell me if/what I'm missing.

The APYs are derived from the user swap fees from swapping tokens on a given platform, powered by an Automated Market Maker (AMM). Exchanges may also earn revenue on the price spread difference, the price difference confirmed by the user and the price at the time of execution.

Using 1inch.exchange as an example,

1. Sample user swap fees: 0.36%

2. Recent monthly trade volume: $6B

3. Monthly exchange revenue: $43.2M

   a. Monthly swap fee revenue: $21.6M

   b. Price spread revenue: $21.6M (Let's assume it's equal to the swap fee revenue to be generous)

4. Considering the total users' LP principal staked is $1K, given a pool like LDO-stETH (64.13% APY/5.34% monthly yield), the total user revenue is $53.44.

5. However, let's say the total user's LP principal staked is $1.5B. The users' revenue, $80M, is 2x the exchange's revenue, $43.2M for the month.

See the sample calculations.

Answer 1

As explained in the r/1inch post here, in my example from Step 5 above, as the staked liquidity approaches $1.5B, the APY would decrease due to the increased supply, assuming the trade volume remains constant.

Rewards for Top 10 Liquidity Pools

Looking at the current Top 10 liquidity pools (LPs) in terms of liquidity volume, the total liquidity is $2B, with a weighted average of 12.74% APY. This would result in the total rewards for the top 10 LPs being $253M for the year.

Taking the estimated 1inch exchange revenue from the original post above and annualizing it, 1inch would make $518M in revenue, on trade fees and price spread revenue, paying out $253M of rewards to the LPs from the revenue.

See the Rewards for Top 10 Liquidity Pools sample calculation.