Chapter 19

Liquidity Provider (LP), Liquidity Pools, Yield Farming. What is it about?

Before going into more detail about Liquidity Providing let's have a look at the concept of liquidity first.

What is Liquidity?

Liquidity can be thought of as a bucket into which people or exchanges/trading platforms put their assets that they do not need immediately. 


In financial and cryptocurrency markets, exchanges/trading platforms hold different buckets that contain x amount of currencies/cryptocurrencies/tokens* (*assets) that can be exchanged. When they have a low supply on a specific asset available, they have so called Low Liquidity. From a client's perspective, low liquidity makes it less attractive to buy or exchange assets on such an exchange/trading platform since the chance exists that they cannot meet the demand. To solve this problem, these exchanges/trading platforms can buy a huge pile of reserve assets to meet expected demand or they can look for alternative methods to ensure sufficient liquidity.


What are Liquidity Pools?
So in the previous paragraph we talked about these buckets containing assets* (*cryptocurrencies/tokens) and how exchanges/trading platforms use these right? One of the alternative methods to ensure sufficient liquidity in the world of cryptocurrencies and DeFi (Decentralized Finance) are Liquidity Pools.

When users of these decentralized exchanges/trading platforms own buckets with different assets that they don’t immediately need, they can put them to work by emptying their buckets into a large pool of such a specific asset which creates a Liquidity Pool. Other users can then borrow, loan, or trade these assets. In return the Liquidity Provider gets a share of the fees on trades that take place in that pool in accordance with their percentage ownership of the liquidity pool. This is a sort of passive income.

Something to keep in mind is that some liquidity pools offer this share in the form of various tokens as payment methods.

What is Liquidity Providing (LP)?


Liquidity providing (also known as Yield Farming) is about putting your crypto assets to work instead of simply holding them. You can do that by staking* your assets for example (*a topic we explained in chapter 5 of our free guide), another way is liquidity providing.

A user that provides his crypto assets to a Liquidity Pool on a exchange/trading platform to contribute to the volume of the Liquidity Pool for trading is known as a liquidity provider (alternatively known as a market maker). When providing liquidity you temporarily lock your assets in a digital smart contract. You then earn a passive income (depending on the terms in the smart contract) from transaction fees, token rewards, interest and rate hikes.

As with most things it is smart to read up well before you start with providing liquidity.


How to earn a passive income when you are Liquidity Providing?


Transaction fees
Transaction fees vary between different protocols and their associated liquidity pools. Inform yourself well before you start. What are the specific terms and what’s in it for you?

Token incentives / Token rewards

Token incentives are an additional "incentive" or reward provided by some exchanges and trading platforms instead of or in addition to fee payouts.

As an illustration, a Governance token may be such a token. A platform's future decisions can be voted on by holders of these governance tokens. Since these governance tokens are freely tradable, they could also generate extra income for you. Liquidity mining, which is the process of accumulating these governance or incentive tokens, helps the network become more decentralized.

Interest

When picking a platform, the amount of interest you receive on your share of the contribution is a crucial factor.


Rate hikes

Another option is to simply profit from any increases in the price of the crypto assets you provide to a liquidity pool. Price declines for those specific crypto assets, however, are of course an additional risk. 



What are the risks of Liquidity Providing?


Cost-effectiveness
Because of the platform's underlying network's transaction costs, providing liquidity in small amounts may not be profitable at all. You have to pay these transaction fees for each activity you do, such as providing liquidity to a liquidity pool or executing a token swap. Take note of this.


Smart Contract risks

Sometimes the developers that create the smart contracts for a project may not be technically competent enough, resulting in weak code that may be vulnerable to hacking or the protocol may not work as intended due to so called bugs


Depreciation of your assets
Despite the fact that you generate transaction fees, governance token incentives, and additional interest due to your liquidity providing activity. In the end you still benefit little if your assets lose value.


Complexity
The most profitable Liquidity Providing strategies are very complex and really only meant for advanced traders.

Liquidation risk

Liquidation when taking out a loan through a platform that provides this because your "collateral" is no longer meeting the necessary coverage ratio. 


Impermanent loss

This means that rather than adding to a liquidity pool, you would have been better off keeping your coins in a wallet.


Regulatory risk
The rules governing the handling of cryptocurrencies throughout the world are still evolving. Since it has concluded that some digital assets qualify as securities, the Securities and Exchange Commission (SEC) is now in charge of regulating them. Some centralised platforms already have been deemed as suspended or cancelled because of this. The value of the project's crypto tokens and that of their ecosystem partners that are specifically impacted might decrease dramatically if such an adjustment results from an SEC judgement. This can cause serious temporary market panic.

Rug Pulls
Rug Pulls are an exit scam where the developers of a new cryptocurrency project collect money from investors for their product and then abandon it to keep the investors' money.

What are the advantages of Liquidity Providing?

Let’s find out what some of the advantages are of Liquidity Providing.
Wherever there is risk, there is also a reward.

Possible profitable Return on investment (ROI)

Users that can easily adapt their strategy or a new project or strategy can grab huge profits from it, which they can use/reinvest in other DeFi projects for even more profits.

Make your assets work for you

Instead of simply holding on to your assets hoping the value increases over time, you Can put them to work in your advantage and earn a passive income

Open Governance

The governance tokens are available to everyone, and they may be used to cast votes on project-related development proposals and other decisions. This leads to a more open approach that enables even small investors to take part in a market's expansion.

Flexible terms

With Liquidity Pools, you aren’t required to have a fixed lock up time. This means that you can adjust the liquidity level as desired. If you feel exposed and vulnerable in a certain pool, it is easy to immediately get out.

Compound Interest

Compound interest operates in a dynamic way, in compared to banks where interest rates are fixed.The compound interest fluctuates according to the state of a specific liquidity pool.
Lendings have low yearly interest rates when there is a large quantity of cryptocurrency accessible in a liquidity pool.

However, the Compound Annual Percentage Yield (APY)* is high for a smaller pool with a lower balance. The yearly return therefore is higher when lending cryptocurrency to smaller liquidity pools. This type of floating interest is beneficial at maintaining some balance in the cryptocurrency market. Users are therefore motivated to provide liquidity to smaller pools since the compounding return is higher.


Similar to how there is enough money to lend, the interest rate is lower when lending
from a larger pool. On the other hand, lending from a smaller liquidity pool has a higher interest rate.


*Annual Percentage Yield (APY) = This percentage shows how much interest per year you get for contributing to a pool.

"Liquidity is oxygen for a financial system." 
- Ruth Porat

What are the best / most common platforms for Liquidity Providing/Yield Farming?


Let’s start with a very innovative platform that we like very much first.

Thorswap (built on Thorchain)

Thorswap is a multi-blockchain Decentralised Exchange aggregator built on THORChain's cross-chain liquidity protocol. THORswap currently supports cross-chain L1 swaps between 25+ crypto assets across 8 major L1 blockchains in a decentralised and non-custodial manner. Liquidity providers can also add liquidity to each underlying liquidity pool, allowing BTC holders to earn yield on native BTC (no wrapped or pegged BTC required). 


Other commonly used platforms are:

Uniswap
Aave

Pancakeswap

Sushiswap

Curve Finance

Synthetix Network
Compound



What People Say About Us

Share by: