Providing liquidity on DEX
Decentralized exchanges are the reason why liquidity provision and profitable farming emerged in the first place. It is on decentralized exchanges that people exchange their cryptocurrencies without an intermediary.
DeFi projects related to the liquidity reserve are a very complicated thing. Therefore, we need to start from the beginning to clarify the basic principles.
What is DeFi
The term DeFi (according to Coinmarketrate.com ), means decentralized financing. Its definition is in principle simple. It’s just finance and the financial system, but in a decentralized form. Usually, a blockchain or another type of decentralized registry is used for this, which provides the possibility of functioning without a central authority. Thus, DeFi is trying to create a decentralized alternative to, for example, exchanges, brokers, banks, as well as many other traditional institutions that we know in the classical world of finance.
Thus, decentralized finance is understood as a system that, based on smart contracts, allows people to buy, sell, lend and borrow money (in the form of cryptocurrencies) according to the peer-to-peer principle (equal to equal – directly between people). We are talking about smart contracts here, but in the broadest sense, Bitcoin can be called the basis of decentralized finance, which allows you to move capital between people without using any intermediaries other than the protocol itself.
However, in reality, what is called DeFi works on platform blockchains, such as Ethereum, Solana, Binance Smart Chain, etc., which allow you to run only smart contracts and decentralized applications. Thus, in addition to decentralized exchanges and cryptocurrencies for transactions, products that allow people to earn interest on deposited cryptocurrencies are also called decentralized finance.
This is also one of the main reasons why this area is so interesting. Simply because it offers significantly higher interest rates than the products of traditional financial institutions, and it is possible to build a more or less passive income with very interesting interest rates.
In addition, cryptocurrencies can be interest-bearing, the rate of which is fixed in relation to the fiat currency. In particular, these are, for example, cryptocurrency loans, the provision of liquidity or, again, in a somewhat broader sense, staking, such as, for example, Decimal Chain (DEL) offers. But there are even more different subdomains, where theoretically we are talking, for example, about forecast markets and the like.
Decentralized exchanges – DEX
Decentralized exchanges (DEX) are, in short, a decentralized alternative to centralized exchangers and exchanges. These are decentralized applications that, of course, run entirely on the blockchain (or another type of decentralized ledger).
The main difference from traditional centralized exchanges here is that the exchange of cryptocurrencies is completely peer-to-peer, that is, peer-to-peer. Or, as in lending, based on cryptocurrency pools (liquidity pools), from which your transaction is calculated. However, the intermediary here in all cases is a protocol, whether it is a book of applications and proposals on the blockchain (on-chain and off-chain), on the basis of which transactions are settled, or the so-called Automated Market Maker (AMM) exchanges, where transactions are settled from liquidity pools.
Automated Market Maker (AMM) decentralized exchanges are also the most popular type of decentralized exchanges at the moment, where they allow you to be interested in cryptocurrency based on the provision of liquidity. We’ll get to that in the next paragraph.
So, decentralized exchanges are interesting not only for the interest rate on cryptocurrencies, but also because they allow you to operate cryptocurrencies in a truly decentralized and anonymous manner (without any KYC). In addition, they offer the opportunity to buy cryptocurrencies at the very beginning of their existence, before they appear on various centralized exchanges. Thus, it is here that you can buy, for example, various memcoins with the potential of a hundredfold or more increase in value.
But cryptocurrencies with the greatest potential have the greatest risk at the same time.
Currently, decentralized exchanges can be found on most well-known blockchain platforms. The most famous of them are UniSwap, SushiSwap, dYdX, PancakeSwap and others.
Providing liquidity
So, now we know what decentralized exchanges are. We also know how to buy cryptocurrencies or trade them in general. But how to use decentralized exchanges for interest in cryptocurrency? It is here that the provision of liquidity comes to the rescue, on which you can earn very interesting interest. And in this case, in addition to the usual crypt, it opens up the possibility of working with stablecoins (i.e. cryptocurrencies with a fixed exchange rate, for example, to the dollar).
And so, what is the provision of liquidity?
Providing liquidity is the process of blocking cryptocurrencies in so-called liquidity pools on a selected decentralized exchange. In particular, in the vast majority of cases, these are decentralized exchanges AMM (Automated Market Making), that is, the most popular at the moment.
So, for example, this is when you block 2 different cryptocurrencies in 2 pools on this currency pair. Both pools should always have the same value (most often expressed in the native cryptocurrency of the blockchain on which a particular decentralized exchange operates) at any time. Related to this is the fact that you also have to lock a certain amount of cryptocurrency in two pools, which will have the same value in both cases.
By investing in liquidity pools created by smart contracts, you thereby provide liquidity in this market. This is due to the fact that transactions on decentralized AMM exchanges are settled from liquidity pools. Then the price is formed from the ratio of cryptocurrencies of the first and second pool. Although pools always have the same value, the ratio of cryptocurrencies in them changes with each transaction. This means that, for example, if you buy one cryptocurrency for another, the number of cryptocurrencies in the pool of the cryptocurrency you buy will decrease, and the number of cryptocurrencies in the other pool will increase. This will also increase the rate of the cryptocurrency you are buying compared to the one you are buying.
But what makes a profit?
Then you get the opportunity to additionally “interest” your cryptocurrencies, in exchange for providing liquidity. But where does this interest come from? Even on decentralized exchanges, you usually have to pay a commission for trading. However, as a rule, they are not sent to developers (maybe part for development or reserve funds), not to mention some centralized structure, but directly to liquidity providers (LP).
By starting to provide liquidity, you get a share of the trading fees of users of a decentralized exchange. This is the share that is determined by how much liquidity for a given currency pair is provided directly by you.
Another option may be various so-called boosters. In them, the team of the selected project decides to add an additional reward in the form of its own token to people providing liquidity. This often happens in very new projects when the team wants to encourage people to start providing liquidity in order to increase it on a given currency pair (and reduce the impact on the price, for example, transactions with higher capitals, etc.).
Conclusion
Liquidity pools are a very good opportunity to monetize your cryptocurrencies to a greater extent than if you just kept them on your wallet. You receive a percentage of passive income for providing liquidity. Although, again, no one gives you anything for free.
This can be a very good passive income added to your HODL, however, you need to choose projects very carefully, because if you automatically switch to a new unaudited project, you can lose your savings just as quickly.