DeFi Part 7: Liquidity and Liquidity Providers

Now that you understand decentralized lending and staking, it’s time we moved on to some of the more sophisticated earning opportunities in decentralized finance.

To that end, this intro to yield farming is going to help you figure out everything you need to add another potential source of returns for your DeFi portfolio.

We’ll discuss what becoming a liquidity provider entails, of course. To understand that, however, you’ll need some background knowledge on the concept of liquidity, its importance, and how you can profit by becoming a liquidity provider.

Let’s jump right into it.

Table of Contents

  • Understanding Liquidity and Its Role in Decentralized Finance
    • Token Example
    • The Crucial Role of Vast Liquid Reserves
  • Generating Positive Returns with Yield Farming
    • A Quick Recap
    • The Opportunity for Liquidity Providers
  • Key Takeaways

Understanding Liquidity and Its Role in Decentralized Finance

As we discussed in one of the previous installments, decentralized exchanges sit at the edge of decentralized finance innovation. Before projects hit it big enough to secure a listing on centralized exchanges like Coinbase, they start on DEXes and grow from there.

The way exchanges work is they maintain a pool of two or more assets. For example, if you wanted to exchange Bitcoin for Ethereum, there must be someone else willing to sell the same amount of Ethereum and buy the same amount of Bitcoin that you’re selling. As such, the more Bitcoin and Ethereum there are in a market, the more liquidity there is for this pair.

Now, unlike centralized exchanges where corporations can inject investor-backed capital for liquidity, decentralized exchanges don’t have any built-in reserves.

Operating on the automated market maker (AMM) model, decentralized exchanges match willing buyers and sellers. They don’t maintain any team-owned reserves.

Token Example

An easier way to understand is to look at it through the lens of a new project. Let’s say you wanted to launch a cryptocurrency token of your own.

Using a platform like Binance Smart Chain (BSC), you can create a token within hours from now. Better yet, you can mint a couple of billion coins of your very own token and message Forbes to include you on their list of billionaires.

As you can imagine, there is one minor catch. For your token to be worth something, others must be willing to buy it and have a platform to buy it from. That’s where decentralized exchanges come in.

By listing your token on there, you can enable other people to buy your token. However, you’ll need to add an equal amount (in dollar terms) of some other popular cryptocurrency. This is known as a liquidity pool.

For instance, if you add 1,000 UST (a stablecoin worth $1 each) and 1,000 of your token to a liquidity pool, then the price of your token will be $1 each.

The Crucial Role of Vast Liquidity Reserves

To prevent someone from buying up all your liquidity, the decentralized exchange will automatically adjust the price based on the ratio of UST and your token. So the more people buy your token, the higher its price will be. The opposite holds equally true.

Unfortunately, that also means that a single sizable purchase could wildly swing the price of your token and make it impossible for large traders to participate. This is where the demand for liquidity comes in. The more liquidity a project has, the more likely it is to attract bigger and bigger investors.

In other words, liquidity is the lifeblood of any decentralized finance project. Without it, projects can die prematurely before they ever get the chance to grow.

As you can imagine, creators value liquidity above all else. This is where individual investors like yourself can come in.

Generating Positive Returns with Yield Farming

We’ve established the importance of liquidity for decentralized exchanges and the DeFi projects trading on them. The good news is that anyone can fill this gap through what’s known as yield farming.

If images of hard men toiling across vast stretches of farmland are swimming in your mind, then we have some good news. That’s not the type of farming we’re discussing here.

Yield farming is the process where investors can add their crypto assets into a liquidity pool and “farm” yield out of it. That’s just a crypto term for generating profits from your investment through liquidity pools.

It can be hard to keep track of all these terms. So let’s take a step back and recap the salient points for clarity before we move on to the practical implications of yield farming.

A Quick Recap

Decentralized exchanges use liquidity pools (usually a pair of two crypto assets) to facilitate exchanges. For a trade to happen, two parties must be willing to buy and sell the respective assets.

Using the automated market maker (AMM) model, decentralized exchanges automatically adjust the price of assets in a liquidity pool depending on their ratio. The higher the supply of an asset, the lower its price will be. This way one person won’t be able to gobble up all the liquidity.

Now, since decentralized exchanges don’t have liquidity of their own, they rely on users to provide that liquidity.

The Opportunity for Liquidity Providers

Decentralized exchanges know that people won’t just deposit their assets out of the kindness of their hearts. That’s why they came up with an incentive model to reward liquidity providers.

In return for depositing your assets into a liquidity pool, you become a part-owner of it. Your ownership is directly proportional to the percentage of liquidity you own within that pool. In fact, you’ll get LP (liquidity provider) tokens in return for your contribution. You can think of these LP tokens as the shares of any corporation.

Now, liquidity pools generate revenue by charging a small fee on all transactions. This fee typically hovers around 0.3%, although it can range between 0.05% and 1% depending on the volatility and risk profile of the assets in the pool. These figures represent Uniswap (the biggest decentralized exchange), so the numbers for other platforms may vary.

As a part-owner of the liquidity pool, you’re entitled to a share of the profits directly proportion to your stake within that pool. So if the pool generates 100 bitcoins worth of monthly trading volume and you own 1% of the entire pool, then you’ll be entitled to roughly one bitcoin per month.

It’s worth remembering that this example is for illustrative purposes only. The actual figures are far more complicated and can vary wildly from time to time.

With all these concepts covered, you’re ready to explore the practical implications of providing liquidity and profiting from it. In fact, there’s more than one way to leverage this opportunity, as you’ll discover in the next installment of this series.

Key Takeaways

  • Liquidity is the lifeblood of decentralized finance. For exchanges and any projects to survive, they need a ready supply of a popular cryptocurrency to allow trading of their own token.

Anyone can deposit their assets into a liquidity pool and earn a share in its revenue in proportion to their stake.

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