We’re continuing on the topic of Decentralized Finance this week. If you haven’t already, I’d suggest you read last weeks’ post. I promise it‘s short 😁
Liquidity mining is an advanced topic in Yield Farming. Unlike parking your coins in a money market like Aave or Compound, you can put your Ethereum tokens to work in a Liquidity Pool.
How Do Liquidity Pools Work?
If you’re reading this blog, you’ve probably at least heard of cryptocurrency exchanges such as Coinbase and Binance. These are centralized companies. They list hundreds of coins and allow you to trade them for each other. They can do this because they have millions of users‘ funds stored in their system.
Say I want to trade and withdraw 1 Bitcoin for Monero for example. Binance has millions of dollars‘ worth of Monero in its custody. This is liquidity. Binance will take from these stores and send you the Monero you desire. They wouldn’t be able to do that if they had 10 dollars‘ worth of Monero. That’s sucky liquidity. You’d have to wait until someone else wants my 1 Bitcoin for their Monero equivalent (which could take a long while). As you can imagine, liquidity is life blood to an exchange. They need people to park their money in their platform if they want to function in a reasonable amount of time.
Getting Paid for Liquidity
Corporations like Binance and Coinbase are moving the equivalent of billions of dollars a week in cryptocurrency. Beginners might not have heard of this one: Uniswap. Uniswap is about two years old now. It’s volume is even greater than Coinbase. It‘s is a decentralized exchange that allows you to swap your Ethereum tokens for any other Ethereum token. Like any exchange, it needs liquidity in order to work. Unlike the centralized exchanges, Uniswap will pay fees for money parked in their exchange.
Every time someone makes a swap of a particular pair, a fee is paid out to the liquidity providers (aka potentially you!) proportional to the amount invested. If I want to swap 10 Dai to Eth for example, I would pay a nominal fee on this transaction. The people who‘ve parked their money in the platform for this pair get rewarded for it with your fee.
Risks (Impermanent Losses)
Check this out. When providing liquidity to a platform such as Uniswap, you deposit two tokens in a 50:50 ratio. As you see in the chart below, you have 200 dollars of total value. This is split between 2 assets equally.
+----------+-------------+-----------+--------------+
| | Price | Deposited | Value |
+----------+-------------+-----------+--------------+
| Token A | 25 dollars | 4 | 100 dollars |
+----------+-------------+-----------+--------------+
| Token B | 10 dollars | 10 | 100 dollars |
+----------+-------------+-----------+--------------+
Token B is the volatile element in comparison to A stable coin. If B randomly doubles in price, it becomes unequal.
+----------+--------------+-----------+--------------+
| | Price | Deposited | Value |
+----------+--------------+-----------+--------------+
| Token A | 25 dollars | 4 | 100 dollars |
+----------+--------------+-----------+--------------+
| Token B | 20 dollars | 10 | 200 dollars |
+----------+--------------+-----------+--------------+
It will attempt to even itself back to 50/50
+---------+------------+-----------+-------------+
| | Price | Deposited | Value |
+---------+------------+-----------+-------------+
| Token A | 25 dollars | 6 | 150 dollars |
+---------+------------+-----------+-------------+
| Token B | 20 dollars | 7.5 | 150 dollars |
+---------+------------+-----------+-------------+
The price of Token B may fluctuate in respect to Token A. When this happens, the amount of tokens that you have in the deposited column with re-adjust to look a little like this. However, instead of having an equal amount of each value (150 and 150), you’ll lose a little of each token in equal value to arbitrage and/or price slippage. You may end up in a loss of a few dollars of value even accounting for the gain of rewards from fees.
This is “impermanent” because you will regain the lost money when the price ratio returns to how it used to be. Price volatility will cost the liquidity provider money. If the relative price of the assets appreciate or depreciate in tandem then the liquidity provider will make a lot of money. This is will almost certainly happen as long as you leave your money on the platform long enough. Of course that could take a really really long time. Maybe even years
Token Rewards
Providing liquidity can be an easy way to earn airdropped tokens while increasing your income. On top of fees, platforms like Balancer and most recently Uniswap, have created their own tokens. Other tokens also use liquidity mining as a method of token distribution. These are dispensed to liquidity providers on top of the income from fees. Tokens won‘t be distributed indefinitely, but it‘s a very significant factor for the time that it‘s available. This bonus income will tip the scale on the profitability of providing liquidity vs HODLing.
How to Provide Liquidity
- Here are step by step instructions for Balancer. Unlike Uniswap, balancer allows pools of arbitrary proportions.
- Here are the instructions for Uniswap
Conclusion
This article ended up running a little long and a little low on examples with calculated numbers 😅
I hope you find the links helpful. This is a very complex topic and there are sources that go into real world calculations of the profitability. Consider weekly digests of this content and more.
If you’re looking to purchase ETH for liquidity mining, I’d suggest putting in smaller amounts at a time. Gas fees are still high, but you can use CardxCoin to buy gas fee free ETH with unwanted gift cards or just your debit card. Just enter the address you want to have it sent to.