"New" Passive Income Method: Liquidity Pools - Part 2
What is Impermanent Loss?
Impermanent Loss happens when the price of your deposited assets changes compared to when you put them in the Liquidity Pool.
It’s called “impermanent” because the loss only becomes “permanent” if you decide to withdraw your liquidity from the pool. Until you do, there’s a chance that the asset prices could shift back in your favor.
Your tokens in the Liquidity Pool will change in value (either higher or lower) depending on the demand for them, by the traders in the DEX.
If you withdraw your tokens from the Liquidity Pool, this impermanent loss then becomes permanent. However, until you do, your tokens’ value could go up — hence the phrase “Impermanent Loss”.
How Do You Earn From Liquidity Pools?
Assuming neither of the tokens you deposit in a Liquidity Pool is a stablecoin (like USDT):
1. From the Appreciation of Crypto A:
– If Crypto A’s value increases over time due to external market dynamics, the intrinsic value of your holdings in Crypto A would rise.
– Note, however, that while the asset’s price might be increasing, the exact number of Crypto A you own in the pool might decrease due to trading activity. Still, if the appreciation is substantial, the overall worth of your holdings might still be higher.
– However, if Crypto A’s value decreases, your holdings’ value decreases too.
2. From the Appreciation of Crypto B:
– This is similar to the above for Crypto A, but for the second asset in the pool. If Crypto B’s value increases, the worth of your holdings in Crypto B rises.
– Again, keep in mind the number of Crypto B tokens you own in the Liquidity Pool might fluctuate due to traders buying and selling them in the DEX, which might impact the total value of your holdings in Crypto B.
3. From the Liquidity Pool’s Own Token:
– This is a reward mechanism many DEXs use to incentivize users to provide liquidity. When you deposit assets into a Liquidity Pool, the platform might give you a special token, often referred to as a “Pool Token” or “Liquidity Token.”
– This Liquidity Token represents your share in the pool and can sometimes have its own market value. You can potentially sell it or use it in other DeFi protocols.
– Additionally, some platforms use these tokens as governance tokens, allowing holders to vote on protocol changes, upgrades, or other community decisions. Having a say in the protocol’s direction might be appealing to some investors.
4. From Trading Fees:
– Every time a user makes a trade using the Liquidity Pool, they typically pay a fee to the DEX. This fee is compensation for the Liquidity Providers (you) since they’re the ones allowing the trade to happen by depositing their assets.
– As a Liquidity Provider, you earn a portion of these fees. The exact percentage you get is proportional to your contribution to the pool. For instance, if you’ve provided 1% of the pool’s liquidity, you’d typically earn 1% of the trading fees.
– Over time, especially in high-volume Liquidity Pools, these fees can accumulate and represent a significant source of passive income. However, it’s worth noting that Liquidity Pools with low trading activity might not generate substantial fees.
The above are the main ways to earn from Liquidity Pools. There are others, and they can take the following forms:
1. Bonus Rewards
– Many DeFi protocols form partnerships or collaborations to enhance their attractiveness to potential liquidity providers. As part of these partnerships, Liquidity Providers might receive extra tokens (apart from the usual rewards) from the partnered protocol.
– For example, a DEX might partner with a newly launched token project to incentivize liquidity in that token’s pool. Liquidity providers in that particular pool could receive the new token as a bonus reward.
– This can be a way to distribute and promote new tokens or to draw attention to a particular pool.
2. Yield Optimizers:
– Instead of manually reinvesting your rewards back into the pool, some platforms do this automatically for you. By compounding your rewards, they seek to increase your overall return over time.
– Think of it like earning interest in a bank account, and then earning interest on that interest (Einstein’s “8th Wonder Of The World”). Over time, this compounding effect can significantly boost your total yield.
– It’s important that you vet these platforms, as the underlying smart contracts on them can be complex and might carry risks of bugs or vulnerabilities.
3. Lending the LP Tokens:
– Once you’ve deposited assets into a Liquidity Pool, you typically receive LP tokens representing your share. Some DeFi protocols allow you to lend out these LP tokens to other users.
– This is similar to how you’d lend out regular cryptocurrencies and earn interest. Borrowers might want these LP tokens for a range of reasons, such as leveraging their position or participating in other DeFi strategies.
– But remember, lending always carries risks. If the borrower defaults or the platform has vulnerabilities, you could lose your assets.
4. Participate in Protocol Governance:
– Many DeFi projects are community-driven and rely on token holders to make decisions about the protocol’s future. These decisions can relate to upgrades, changes in fee structures, partnerships, and other significant matters.
– By participating in governance, you can influence decisions that might increase the protocol’s success and, indirectly, the value of the tokens you hold. Plus, some proposals might introduce new rewards or incentives for liquidity providers, directly benefiting you.
5. Layered Farming:
– This is an advanced strategy where users leverage their LP tokens even further. For instance, after providing liquidity and earning LP tokens, a user might deposit those tokens as collateral to mint a synthetic asset or borrow another asset.
– They can then use this borrowed asset to participate in other yield-generating activities, effectively creating a layered yield strategy.
– It’s a way to maximize potential rewards but comes with compounded risks. If something goes wrong in one layer (e.g., a sudden price drop), it could cascade and jeopardize your position in other layers.
Note that with increased potential rewards come increased risks. If you want to follow any of these strategies, do thorough research, understand the mechanics involved, and assess your own risk tolerance.
Now that you know what Liquidity Pools are and how you can earn from being a Liquidity Provider, here are several DEXs that offer liquidity pool opportunities:
– Platform: Ethereum
– Overview: One of the most popular and recognized DEXs in the crypto space. It offers various pools for Liquidity Providers.
– Platform: Ethereum and others (it has expanded to multiple blockchains)
– Overview: Originally a fork of Uniswap, SushiSwap has since introduced additional features and products, making it a notable player in the space.
3. Curve Finance:
– Platform: Ethereum
– Overview: Focused primarily on stablecoins. This makes it particularly attractive for those wanting to provide liquidity with assets that have relatively stable prices.
– Platform: Binance Smart Chain (BSC)
– Overview: A leading DEX on BSC, PancakeSwap is similar in function to Uniswap but operates on Binance’s chain, often offering lower fees than Ethereum-based platforms.
5. Kyber Network:
– Platform: Ethereum
– Overview: A liquidity protocol that aggregates liquidity from various sources to provide competitive rates.
– Platform: Ethereum and Binance Smart Chain
– Overview: A DEX aggregator that sources liquidity from various exchanges, ensuring users get the best rates. While it’s primarily an aggregator, it also has its own liquidity pools.
– Platform: Polygon (previously Matic Network)
– Overview: An DEX on the Polygon network, offering faster transactions and lower fees compared to Ethereum-based DEXs.
8. ThorChain (RUNE):
– Platform: Multi-chain
– Overview: A cross-chain liquidity protocol allowing users to swap assets from different blockchains without relying on wrapped or synthetic tokens.
I will cover what wrapped tokens and synthetic tokens in a later post.