Earning Cryptocurrencies on Providing Liquidity
Providing liquidity on DEX is one of the most popular trends in the world of decentralized finance. According to DeFiPulse, more than $80 billion has been blocked on various DeFi protocols. Since 2020, this type of earnings on crypto has conquered the entire DeFi ecosystem, offering investors a reward for blocking their crypto assets, and many wanted to know better what farming is.
Let’s consider the earnings of liquidity providers and their components, their attractiveness to investors, and possible risks.
Collecting liquidity is a way to get a commission for investing coins in a liquidity pool. It includes the provision of cryptocurrency on credit. The investor invests cryptocurrency in the lending protocol in order to receive interest from trading fees.
Instead of crypto, the liquidity provider continually provides liquidity and receives commissions, although often less than when distributing a new cryptocurrency.
How to make money by providing liquidity?
Providing liquidity is in many ways something similar to bank loans. When a bank lends money to a client, he pays the loan with interest. Becoming a liquidity provider is the same thing, but in this case, banks are the same holders of cryptocurrency.
Blocked cryptocurrencies are used to provide liquidity in DeFi protocols in exchange for profits from trading commissions.
The interaction takes place between the liquidity provider (LP) and the liquidity pool, which is a smart contract with money. This smart contract supports the operation of the DeFi market.
A liquidity provider is an investor who invests in such a smart contract. Profit distribution functions are based on the Automated Market Maker (AMM) model, a model popular on decentralized exchanges.
AMM excludes the usual order book (order book), which contains all purchase and sale orders on the crypto exchange. Instead of specifying the price at which an asset should be traded, an automated market maker creates pools of liquidity using smart contracts. These pools execute trades based on predefined algorithms.
The AMM model relies heavily on liquidity providers. Liquidity pools are the basis of most DeFi trading platforms, where users borrow, lend and exchange tokens. Users of such platforms pay a trading commission, and the trading platform distributes the commission between liquidity providers depending on their share in the pool.
They receive a commission in full (0.3%) if the exchange is made after clicking on the provider’s personal link within the provided liquidity at the exchange rate at the time of adding liquidity. If the exchange volume exceeds the amount of funds blocked by the provider in the pool, the commission is distributed among all providers according to their share in the pool.
Smart contracts serve as an agreement mechanism to ensure transactions between market participants.
How do I find out the total blocked cost (TVL)?
The total value of the blocked funds –Total Value Locked, or TVL) is the sum of all assets placed to investors in a certain DeFi protocol. TVL is used as an indicator of the general state of the decentralized finance market and the profitable farming market.
To get the coefficient of the total blocked value, you need to take this value of the market capitalization and divide it by the value of the blocked funds in a certain DeFi service.
The TVL value gives an idea of the general capabilities of a particular DeFi service or the entire ecosystem as a whole. Knowing the total amount of money blocked in the system, you can see how much money can be provided by the platform. This is a figure that represents the spot value, most often in fiat US dollars, for all blocked assets.
How is the profit calculated for LP on DEX?
The profitability of a liquidity provider depends on how often its funds are used for exchange, which is provided to the pool of a trading pair.
What are the business models of liquidity providers?
Although the DeFi ecosystem has obvious great growth potential, investing has its risks.
The main ones are:
- Risks of smart contracts that are vulnerable to attacks. They may also contain errors in the code. Users of popular DeFi protocols have already faced losses due to hacker attacks.
- The risk of impermanent loss is caused by the sharp movements of the DeFi market. Usually, automated AMM market makers do not update token prices in accordance with market changes.
- The difficulty for beginners. It is risky for inexperienced users to make money on DEX because you can lose all your investments in one fell swoop. For example, with an increase in the cost of gas that provides transactions, with a small investment, you may find that you cannot withdraw your income due to high gas fees. Always invest only the money that you are ready to lose.
The above is just the foundation. To choose a good liquidity provider, you need to consider a lot more factors.
Efficiency analysis is a time-consuming process. But does it make sense to kill time for this if honesty is in question? Therefore, it is worth starting with checking the regulators of the liquidity provider. Moreover, the reliability of the latter also needs to be checked. Many people have heard about the risks of fraud in the investment market, so you need to work only with a reputable market maker.
The liquidity provider must perform operations immediately as soon as a person applies to it. Deviations are allowed if there is a convincing argument for that. Everyone who cooperates with a market maker should be able to check transactions through automated trading software, which allows you to build detailed statistics. In other words, buying and selling should be transparent.
You need to be absolutely sure that the instruments, like the transactions themselves, are not burdened with swaps. This point requires special care since there are not many liquidity providers in the world of cryptocurrencies offering their own trading technologies and bots.
The provider must have stable and reliable channels without gaps in the charts. The feed should reflect prices on different exchanges and provide tools for comparing them. Access to market history is an integral part of a quality market maker.
Any service operating in the field of finance or investment should display data about its activities. This is correct when a liquidity provider has a complete reporting toolkit, including:
- email notifications;
- reports on closed and open bonds for the requested period;
- profitability report;
- statement with exchange points;
- the history of ticks.
Real examples of decentralized finance liquid market financial institutions
Over the past year, the DeFi market has made a big leap in development and capitalization, and the number of regularly emerging new projects has grown significantly. But not all of them are worth contacting and risking cryptocurrency. Here are examples of some of the safest, most popular, and promising.
The exchange is a type of DEX called an automated market maker (AMM). Prices for various pairs of tokens are set by the exchange using mathematical formulas, and trading takes place using smart contracts. To do this, there are liquidity pools on the exchange. Uniswap charges a commission of 0.30% on all transactions, which is added to the reserve pool.
When a liquidity provider burns its pool tokens to return its share of the total reserve, it receives a proportionally distributed amount from the total commissions accumulated during the placement of bets.
This is a trading platform that crypto investors use to provide and receive loans in digital assets. This is a decentralized protocol, or DApp, built on the blockchain. Since the beginning of 2021, Compound has returned to its investors more than 100% of their invested funds.
One of the main reasons to invest in Compound is to increase its total blocked value (TVL). This is one of the safest and most reputable blockchain projects. In addition, it is one of the main drivers of the ever-growing DeFi market.
This platform allows users to create pools of liquidity with eight different tokens in any ratio. The decentralized Balancer exchange has become possible thanks to the ever-growing number of assets in these pools. This is probably why Balancer presents itself as an automatic portfolio manager. This is a decentralized exchange, a customizable DEX structure, and a robotic index fund.
This is a landing DeFi protocol that allows you to borrow up to 75% of the collateral amount. Currently, Aave has the highest rating among all lending protocols: its current market capitalization/TVL is much higher than that of Compound. The platform attracts more and more users, and the total amount of assets on the platform has grown dramatically. Aave is also the largest lending protocol, and AAVE is one of the most popular tokens that can be purchased on Coinbase.
DEX exchange was the first to offer a liquidity system in which investors can cover non-permanent losses due to greater profitability. This is achieved due to the absence of the need to share the commission received with other users participating in the liquidity pool. So, on Exon Swap, personal liquidity allows you to get 0.3% of the transaction amount. To do this, you need to block your coins and share a personal link to liquidity.
On this decentralized exchange, profitability can reach great heights if you properly operate your assets. The project community regularly reviews the level of profitability by voting.
The reason for the popularity of earnings on DEX is the desire of cryptocurrency investors to have access to their investments and receive interest from commissions. At the same time, do not forget about caution, and it is necessary to check the DeFi service where you are thinking of investing. Research and constant analysis of the exchange will help to avoid non-permanent losses and banal fraud.
How to reach an agreement with the provider
It should be understood that the DeFi liquidity provider is a full-fledged partner, which means that the relationship should be appropriate. The different business models and capabilities of these liquidity providers allow them to serve the market in different ways. First of all, you need to show the market maker that you are focused on fruitful cooperation. Therefore, it is necessary to determine the list of issues for discussion, among which are mandatory:
What trading interfaces does the liquidity provider offer?
How many resources will a liquidity provider need to create a convenient trading flow? (the level of attractiveness for customers depends on this, and hence the volume of trades on the service).
Are statistics on negative and positive slippage provided? (this parameter will allow you to more accurately calculate future profits, as well as assess the level of the liquidity provider).
Where are the data centers located? (the delay in performing operations depends on this).
Why do we need liquidity providers?
The cryptocurrency market is considered very unstable, especially recently, when it shows only a fall. The attitude of traditional financial institutions towards Bitcoin has long acquired the status of scandalous since the project has lost its position and cannot compete with many altcoins. Nevertheless, it has the highest trading volume, which means that any service should provide the maximum possible liquidity.
This can be done on your own, but you will have to spend a lot of effort and resources. Accordingly, there will be no time left for the development of the exchange itself or the exchange service. That is why it is recommended to use the services of liquidity providers. It is necessary to take care of this almost in the first place. After all, the high liquidity of trading pairs is a direct way to the success of the project and attract new investors.
You can approach this issue as responsibly as possible, taking everything into your own hands. One of the options is to develop your own exchange and, at the same time, your own liquidity solution. However, it takes a lot of time and resources, and most importantly – special knowledge. To solve the problem, you can order the development of cryptocurrencies or hire a company that develops appropriate software, like Merehead. For several years now, the company has been launching startups in E-commerce, crypto platforms, fintech, P2P, and related fields. They also have their own tools to increase liquidity.
How to find a market maker: results and different business models
Bitcoin liquidity providers always act on the market as buyers and sellers. Since they “make the market,” they have the responsibility to ensure price stability and high trading volumes, as well as to help novice investors reduce risks. The chosen market maker must have high stability indicators.
Priority should be given to companies that have been working for a long time, have a proven reputation, and are focused on long-term cooperation. This gives confidence that he will not retire from business as soon as he receives the first large profit. A liquidity provider should provide broad and developing opportunities, including individual solutions that will allow you to gain an advantage over competitors because any engine of a cryptocurrency exchange should include a liquidity solution or several integrated suppliers-companies.
It is necessary to analyze the prices and channels of the company. A market maker must have extensive tools for working and analyzing the market. One of the key components is a feed with prices on different exchanges, forex market included, including the ability to compare indicators. In addition, gaps in charts or the absence of a quotation history are unacceptable. Cryptocurrencies are exclusively digital assets, and all transactions pass through the network.
But the contact with the liquidity provider should always be at the highest level. We are talking not only about email but also about telephone communication. The provider should be able to answer any questions. But finally, do not choose a cheap option. As a rule, the price reduction is achieved by saving on system maintenance and the development of tools for working in the market. All this only increases the risks, such as technical failures, excessive commissions, low liquidity and trading volume, and an increase in the spread.