In part 7, we talked about the need for liquidity and how liquidity pools operate. You also learned why creators incentive users to deposit their assets and earn rewards in return.
It is time for us to now consider how you too can become a liquidity provider and profit from it. In fact, we’re going to present an additional layer of revenue that’s recently been making waves in this space.
As usual, however, we’ll also cover the downsides of this opportunity and highlight the risks you should consider before buying in.
With so much to cover, let’s jump right in.
Table of Contents
- How Yield Farming Investments Work
- Understanding the Profitability of Yield Farming
- Supercharging Your Returns with Liquidity Mining
- The Risks of Becoming a Liquidity Provider
- Impermanent Loss
- Smart Contract Bugs
- Rug Pulls
- Key Takeaways
How Yield Farming Investments Work
We’ve already laid out a solid foundation of how liquidity pools work and how you can contribute assets to one to generate profits. This process of depositing assets into a liquidity pool and collecting rewards is known as yield farming.
In the vast majority of cases, liquidity pools involve a pair of assets. One is usually a popular, high-demand asset like ETH, whereas the other is typically an emerging asset like AXS (the official token of a popular game called Axie Infinity).
To profit from this opportunity, technically you have to deposit both tokens. However, you can get away with just one by depositing the more in-demand token. In our example, that would be ETH.
Once you do this, the liquidity pool will immediately give you special tokens called liquidy provider tokens. Like the shares of a company, LP tokens represent your stake within that pool. You’re now officially a liquidity provider and will be entitled to a percentage of profits generated by that pool.
Understanding the Profitability of Yield Farming
Yield farming is possibly the most popular of DeFi investment. That’s because every project needs access to liquidity, which means there’s a sea of liquidity pools out there, with new ones popping up every day.
In such a competitive space, emerging projects fight tooth and nail to attract liquidity to their project. So while popular assets only yield single-digit returns, there are exotic pairs that promise returns well beyond that.
For instance, let’s look at the WETH-JPEG liquidity pool on a popular decentralized exchange called SushiSwap. JPEG is a token by a protocol with the same name that’s building a vault of NFTs and allows users to become part-owners of that vault by buying this token. Whereas WETH is just a wrapped version of Ether so it can work on SushiSwap.
Now, unlike the more popular pools, the WETH-JPEG pool offers a far more lucrative return rate. As of this writing, the APY on this pool is estimated to be 32.1%. In practical terms, it means that if you deposit $10,000 worth of WETH today, you’ll get $3,210 worth of JPEG tokens within 12 months from now. Can you imagine generating this level of returns in centralized finance?
Unfortunately, it’s not without a catch. As we’ll discuss in a later section, some drawbacks cannot be ignored.
Supercharging Your Returns with Liquidity Mining
Your stake in a liquidity pool is represented by these special assets called LP tokens. Like any other crypto token, these are real blockchain-powered tokens that can be sent or received. While their primary purpose is to serve as receipts of your deposits, they can do a lot more.
Liquidity is only useful for as long as it stays within the liquidity pool of a project. However, most users do the opposite as they jump from pool to pool in hopes of chasing the highest APY.
It didn’t take long for creators to realize that there’s a mutually-beneficial opportunity on hand. Instead of letting these LP tokens sit idly, they came with up a fantastic solution in the form of LP token staking.
This created a second layer of profits for liquidity providers as they could now stake their lp tokens and earn additional rewards on top of what they were getting for providing the initial liquidity. This is called liquidity mining.
The logic is simple. By incentivizing users to stake their lp tokens, they can get those lp tokens, and thus the initial liquidity is locked for a long time. This prevents the outflow of liquidity to other projects. At the same time, users get to enjoy two streams of returns for maximum ROI.
The rest is history as the vast majority of projects with liquidity pools offer liquidity mining today.
The Risks of Becoming a Liquidity Provider
Whether you pick yield farming alone or supercharge it with yield mining, your portfolio will be exposed to a variety of risks. These threats include but are not limited to:
1. Impermanent Loss
The profits paid by liquidity pools are in the form of tokens, not fiat currency. This means if ether was $2,000 when you deposited it, but it’s hovering around $1,000 by the time you’re ready to withdraw, your impermeant loss is sitting at 50%. Since exotic tokens generate the highest yields, it also means that you’re exposed to higher volatility as well.
2. Smart Contract Bugs
The automated and decentralized nature of these assets makes them permissionless. Anyone can become an owner of a liquidity pool without ever interacting with any person. But the smart contracts powering this coordination can have security loopholes, which hackers can and will exploit. This could potentially evaporate your portfolio into nothing.
3. Rug Pulls
This is one of the most common scams in decentralized finance. Unscrupulous characters raise vast amounts of capital with the lure of attractive return rates, but once a project takes off, they immediately cash out in one of two ways.
They either take all the liquidity out of the pool if it isn’t locked by design. Or they dump their supply of tokens (since they created the token) and drain the more valuable token from the pool that way. The DeFi term for this is “rug pull”.
Key Takeaways
- Yield farming allows you to earn attractive rewards while supporting emerging projects
- Liquidity mining allows you to supercharge your returns by staking the free lp tokens you get in exchange for providing liquidity
- The more exotic the tokens in a liquidity pool are, the wilder their return rates will be. However, this is accompanied by a sharp uptick in the risk of impermanent loss thanks to the extra volatility.
