Yield Farmers: Providing Liquidity on a Decentralized Exchange (DEX)

Yield Farmers: Providing Liquidity on a Decentralized Exchange (DEX)

Every DEX is trying to get crypto HODLers onto their platform as an LP provider by luring them in with a high yield. Here's how to know which ones are legit.

Yield Farmers: Providing Liquidity on a Decentralized Exchange (DEX)
Guy Ovadia

Published May 9, 2022Updated May 9, 2022

DeFi

DeFi

Crypto

Crypto

Technology

Technology

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Yield farming is probably the most popular way to make money in DeFi. Put down your spade and pickaxe, because the only tool you'll be needing is a DeFi wallet, some crypto, and, of course, an internet connection. Yield farming is a way to get up to double-digit APY that you can only dream of making with a regular bank account. However, yield farming is not a money printer, and a basic understanding of how providing liquidity on a decentralized exchange works will help you use this tool wisely.

What is liquidity staking?

If you're staking crypto just to earn more of that same crypto, you should be skeptical about how sustainable that mechanism is.

The way most decentralized exchanges (DEX) work is by having liquidity providers deposit an equal dollar amount of at least two cryptos into a pool that traders use to swap between cryptos. Each time a trader exchanges crypto using a liquidity pool, a percentage of the total volume of the trade is taken as a fee, and part of that fee is distributed proportionally to all liquidity providers of that pool.

LP tokens

Liquidity pool (LP) tokens are rewarded to liquidity providers for locking their liquidity in a pool on DEXs like Uniswap and Curve. Each LP token represents part of the liquidity deposited into the pool and these tokens are used to withdraw liquidity from the pool. Some platforms enable liquidity providers to stake their LP tokens as a way of earning additional crypto yield to incentivize them to lock their cryptos in the pool for longer.

Yield farming

Providing liquidity into a pool and staking the subsequent LP token is called yield farming. Yield farming refers to strategies for maximizing crypto staking yield, which usually means depositing liquidity into an automated market maker (AMM) protocol. Since DEXs don't use an order book system that's used by centralized exchanges like Coinbase and Kraken, an AMM simply refers to the type of smart contracts that are utilized to provide a decentralized source of liquidity for crypto traders.

kraken
Kraken

Crypto

Constant product automated market maker

Since DEXs don't use order books that match crypto buyers with sellers at a price they can both agree on, they must create smart contracts that utilize a constant product AMM formula. Put simply, this formula uses the proportion of the assets in a liquidity pool to determine the price of those assets. This means that when traders utilize liquidity in a certain pool, they will impact the price of assets in that pool.

How an automated market maker works

For example, liquidity providers deposit an equal dollar amount of Crypto A and Crypto B in a pool. When a trader utilizes the pool to sell Crypto A and buy Crypto B, the pool will then have a greater amount of Crypto A than it does Crypto B. Because the constant product formula must keep the dollar amount of assets in the pool equal at all times, this causes the pool to adjust the price of both assets, so Crypto B's price goes up and Crypto A's price goes down.

Divergent loss

When a liquidity pool experiences a high volume of trades in the same direction, this can cause the price of assets in the pool to be different from actual market prices. This could result in a loss for liquidity providers because the market price of an asset going up won't necessarily be reflected by the price in the liquidity pool. 

This divergence also poses an arbitrage opportunity where traders can take advantage of the difference in price between the liquidity pool and another market for the crypto assets in the pool. While this lucrative opportunity can be seen as being at the expense of liquidity providers, this isn't necessarily the case, since arbitrage trades may keep the price of assets in the liquidity pool closer to prices in other markets.

What is protocol staking?

While being a liquidity provider and locking your LP tokens is technically staking, it's important to take note of the distinctions between different types of staking. Not all crypto staking is equal, and while staking is generally a useful mechanism for securing blockchains and DeFi protocols, it's crucial that investors gain an understanding of the fundamental economics at play.

Proof of stake consensus staking

Staking refers to several different mechanisms that require one to lock up their crypto in a smart contract in exchange for a reward. The most basic type of staking is locking crypto to secure a proof of stake blockchain, with Polygon's MATIC and Cosmos's ATOM being among the best proof of stake cryptos. If you don't have the resources to meet the staking minimum and run a validator node 24/7, then delegating your crypto to another validator or using a liquid staking solution are great ways to earn rewards without all the responsibility of running a node.

DeFi staking

If you're not staking the native crypto coin of a blockchain to secure the network, then you're probably staking on a DeFi protocol. First, you have liquidity staking, which we described as locking a couple of cryptos in a pool for traders to be able to freely swap back and forth between them. The fee paid by traders to liquidity provers is denominated in the pool's LP token, and the balance is reflected once the LP tokens are used to withdraw liquidity from the pool.

Yield aggregators

On top of staking liquidity, you can also stake the LP token to earn an additional yield. This is where DeFi can get a bit tricky: You want staking your LP to be worthwhile, otherwise, you'll be wasting potential income. This is where yield aggregators come in handy. Rather than having to scour DeFi to get the best rate for your LP, yield aggregators like Beefy Finance are platforms that consolidate all the relevant staking contracts to allow you to sort through them and find one that gives you the best bang for your buck.

Token staking

If you're not staking crypto in a liquidity pool or staking to yield farm your LP tokens, then you should be careful. Anyone can mint a token and deploy a staking smart contract to create the illusion of yield when they're actually just inflating the currency being staked. In other words, if you're staking crypto just to earn more of that same crypto, you should be skeptical about how sustainable that mechanism is.

This doesn't mean that staking a plain old ERC-20 token is not a good idea, but it does mean you should do your due diligence in terms of the tokenomics at play. DeFi isn't a Chuck-E-Cheese where you just insert 10 tokens and 11 come out, though it may feel that way. The most important part of yield farming is to make sure the asset you're farming will actually have value once everything is said and done and it's time to cash out. 

If you can’t explain it to a six year old, you don’t understand it yourself.

Automated market maker algorithms are arguably the biggest innovation in crypto since proof of stake consensus mechanisms. DEXs live and die by their AMM formula, and the one with the best formula will put the rest to shame by offering traders the lowest fees and liquidity providers the highest yield. While the good old order book may feel antiquated, will it be missed if crypto trading is taken over by DEXs?

If you can’t explain it to a six year old, you don’t understand it yourself.

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