Layer Two (L2) Liquidity pool (LP) farming | DEEP DIVE

4 min readApr 20, 2023

Review of non-custodial farming on VyFinance

Users that supply liquidity to our platform will only need to hold the LP token in their wallet to access farming. This means that the LP tokens held by users are now available to them in their wallets to access, trade, and burn at any time.

Since these LP tokens are now available in the users wallet, we can design a new liquidity pool built from the LP token and another cryptocurrency. We call this a Layer Two Liquidity Pool (L2-LP).

What is a Layer Two Liquidity Pool?

Before we describe a layer two LP, we must first describe a layer one LP (L1-LP). A layer one LP is simply a liquidity pool between any two tokens on a DEx. If you’re familiar with providing liquidity on DExs, then this is a standard liquidity pool.

Once a user has minted a layer one LP token by providing liquidity on VyFinance, they will receive the L1-LP in their wallet, where it will automatically be farming. If the user wishes to boost their farm, they will be able to provide their L1-LP token alongside $ADA to mint an L2-LP.

Fig 1. Example of how tokens can be used to create liquidity. L1-LPs can then be matched with a third token to form Layer two liquidity pools, or L2-LPs

This L2-LP will receive all the farm that the L1-LP would have received, plus extra for providing liquidity to the L1-LPs market. This has the effect of creating a direct market for traders to access LPs. Users on the platform will be able to navigate to our trade screen, select ADA and VYFI LP as an example, determine how much ADA they want to trade, and click confirm. Once the trade is complete and the LP has been received, the user will instantly be farming the LP tokens on our platform. This makes it even easier for new users to access farming as they will not need to provide liquidity to access LP tokens.

What does this mean for traders?

Creating a market between the L1-LP and ADA creates a market price for the LP token. That market price is impacted by buy and sell pressures, which will allow the market price of the LP token (as well as the price of minting the same LP token) to diverge. When traders have access to the same asset at different prices, an arbitrage opportunity emerges. Trades will be able to profit from the difference in the mint value of LPs vs the buy and sell cost of the same LPs on our DEx. This means you can market make with LPs for the first time in Crypto!

Fig 2. Example of arbitrage between L1-LP markets, and burning (removing liquidity) from L1-LPs. This process can also take place in reverse, by minting (adding liquidity) to the L1-LP.

Currently a VYFI/ADA LP contains 1 VYFI and 0.45 ADA. The L1-LP market price for the VYFI/ADA LP is currently 1 ADA per LP. In this circumstance, a trader will be able to mint VYFI/ADA LP at a rate of 0.9 ADA per LP, and sell the same LP on the market at a rate of 1 ADA. They will be able to continue this mint and take profit until the price of the L1-LPs market matches that of the mint price of the L1-LP.

What does this mean for liquidity providers

There are two advantages that a liquidity provider will be able to gain by adding L2-LPs’ to their portfolio:

1) Hedging impermanence risk on liquidity provisions

2) Increased farm for holding liquidity

How does an L2-LP hedge impermanent loss?

By matching your L1-LPs with another cryptocurrency in a liquidity pool, you are now exposing your L1-LPs to impermanent risk. This means that if the value of the LP goes down, you will be earning more of the LP token through impermanent loss within the L2-LP. If the value of your L1-LP goes down, you will be earning more L1-LP.

By engaging in the L2-LP, your portfolio’s structure will change. Let’s say you hold the ADA/VYFI L1-LP. You match this with ADA to enter the ADA/VYFI L2-LP. Your new portfolio structure will be 25% VYFI, and 75% ADA. By adding this extra liquidity, you will experience a reduced impermanent loss of approximately 50% on your ADA, whilst also boosting your farm.

Fig 3. Example portfolio structure from engaging in an L2 LP

Increased farm for holding liquidity

The L2-LPs’ will be accruing all the farm from the L1-LPs’. We will boost all farms to L2-LP providers by 10%. This means users can receive more farm whilst reducing their portfolios outright risk to a given CNT.

What L2-LPs will we be launching with?

Initially, we will be implementing a limited set of L2-LPs as a trial. We intend to launch with a VYFI/ADA and VYFI/DJED L2-LP, alongside L2-LPs for WMT, AGIX and MELD.

We are super excited to bring these new features to Crypto! We believe that, by allowing users complete access to their LP tokens — we can create new tools that have never before been seen on any DEx! We cannot wait to see how the community uses these tools, and takes advantage of the new systems available to them.