A Beginners Guide to Liquidity Providing and Liquidity Mining

In traditional finance, the banks are the gatekeepers, the middlemen. But in DeFi anyone can contribute and be like a bank, reaping the benefits only banks had access to in traditional finance.

Imagine that you can get a portion of the trading fees generated on Nasdaq or any exchange. In DeFi, this is called liquidity providing when anyone with capital can be a market maker on any token pairs and receive a portion of the trading fees.

In this guide, you will learn the basics of what you need to know about DeFi and liquidity providing. By reading this, you will be ready to become a liquidity provider.

Comparing liquidity pools to traditional finance yields

By becoming a liquidity provider, you can achieve higher APY (annual percentage yield) than parking your money in a traditional savings account. We took the top savings account rates in June 2021 and compared them to the average APY of the stable coin pools between January and May 2021.

Good incentive to become a liquidity provider, right?

What is DeFi?

DeFi is a subset of the Ethereum ecosystem that focuses on financial applications. Thanks to the development of smart contracts, DeFi applications can automate many of the activities that are time-consuming and labor intensive in the current system. The growth of these applications is disrupting traditional finance and creating more efficient ways to lend, save and borrow.

What makes DeFi different from traditional finance?

In short, custody of your funds and access to on chain applications. In traditional finance, companies take control of your funds and offer some regulatory protections such as FDIC insurance (in the United States). Companies like Coinbase or BlockFi are custodians of your funds, but in DeFi you are the custodian of your own funds by using wallet software.

What do I need to get started using DeFi to provide liquidity?

To provide liquidity and earn a yield on your crypto assets you need some of those assets in your wallet. Some services will take deposits of a single type of asset, but generally speaking you need two assets to start providing liquidity to pools and begin yield farming.

Get familiar with the tools you will need. We have prepared an article that gives an overview of the basic tools that liquidity providers can use.

What is liquidity providing in DeFi?

Most AMM’s (Automatic Market Makers) that are looking for liquidity providers use a variation of an automated pool reblances based on trading activity. One of the safer ways to start liquidity providing is two use two stablecoins like DAI or USDC to limit your exposure to price fluctuations and impermanent loss (which is explained below). For more information on liquidity pools, check out our previous article “How Do Liquidity Pools Work?”.

What is a stablecoin?

A stablecoin is usually a token that is pegged to a real-world currency like the US dollar. There are many different types of stablecoins, and some are more “stable” than others. The most popular stablecoins that have a good track record of staying close to their dollar peg are USDT, USDC and DAI. Stablecoins do fluctuate in value, but much less drastically than typical non-stable crypto assets.

What are the benefits of liquidity providing?

Liquidity providing is a way to make passive income on your crypto holdings. Although there is some risk involved, the risk is much lower than trading or using leverage. Many people view liquidity providing as an alternative way to have a rebalancing portfolio, as the behavior of automated pools mimics rebalancing. When assets increase in price, the pool sells them. When assets decrease in price, the pool buys more.

What are the risks of liquidity providing?

There are a few risks to consider when dealing with liquidity pools. Anytime you are dealing with smart contracts, there is a risk that the protocol can have a bug or can get hacked. The longer a protocol has been active without having any problems, the lower that risk is.

The other big risk to consider deals with impermanent loss, which will be explained in the next section.

What is impermanent loss?

Impermanent loss is a feature of liquidity pools that happens when there are large swings in the asset prices of the two assets that are in a given pool. Because of the automated nature of the pools, prices can shift quickly based on the amount of liquidity in the pool and cause a loss for liquidity providers due to the automatic rebalancing of the pools.

How can I avoid impermanent loss?

One simple way to avoid impermanent loss is to only deposit funds into stablecoin pools which do not change in value frequently. Stablecoin pools rarely experience significant impermanent loss and are one of the safer liquidity pools you can use from that perspective.

It is much more difficult to avoid impermanent loss in pools comprising two volatile assets. Due to this fact, many protocols will offer rewards (aka yield farming) for liquidity providers to help offset this risk.

What is liquidity mining in DeFi? aka “yield farming”

Liquidity mining, sometimes called yield farming, is the concept that liquidity providers are rewarded with token emissions for providing liquidity to a given pool. In the case of Uniswap, during their liquidity mining program the UNI token was issued on certain pools as a reward to LP’s for keeping their funds locked in the pools. The reason Uniswap was willing to give this reward is that their trading markets are more efficient if more funds are available in the pools.

Ready to get started?

What Do I Need to Provide Liquidity in DeFi?

You will need:

A wallet like Metamask to interact with the a blockchain like Ethereum
You will need to figure out which protocol to deposit into. (ie Uniswap, SushiSwap, Curve) Each protocol has its own features and things to be aware of.
You will need tokens for gas, each blockchain typically has its own gas token. (ie ETH, MATIC) There are services to check current gas prices like Gas.watch.
You will need tokens to deposit into the AMM pools, each pool has its own return profile

Basic Walkthrough of Providing Liquidity (Uniswap will be used for this example)

You will need to hold the two assets you would like to use for liquidity providing in your ERC-20 compatible wallet (Uniswap supports — Metamask, WallectConnect, Coinbase Wallet, Fortmatic, Portis). If you would like to supply $1000 to the ETH/USDC pool, you would need $500 ETH and $500 USDC, plus some extra ETH to cover gas costs. You can check current gas prices at ETH gas.watch. You will need to pay gas to do two transactions, one for approving the token and one to enter the liquidity into the pool.

Using Uniswap on Ethereum

Navigate to the Uniswap App page, connect wallet, and select Pools from the top menu

Click the “Add Liquidity” button and select the pool you want to invest in by selecting the two assets that comprise the pool in the Uniswap interface — NOTE: It is important to verify you have the correct assets selected (many have similar names), you can verify that information using Etherscan, CoinGecko, and Uniswap.info.

Uniswap will quote some current token prices and your projected share of the pool before you hit the Supply button. Once you hit “Supply”, the two assets in your wallet will be exchanged for Uniswap LP tokens, representing your share of the liquidity pool. The tokens will start to earn you fee revenue and expose you to potential impermanent loss.

How can I track my liquidity pools? How do I measure ROI?

Given the volatile nature of crypto markets, it is necessary to have robust tracking tools to ensure good performance when providing liquidity. APY.vision is one such tool that tracks profit, impermanent loss and yield farming rewards for liquidity providers. In the screenshot below you can see how the APY.vision interface gives you all the most important data to help make decisions about how to manage your liquidity pool positions.

If you are ready to move on to more advanced topics, check out our “Ultimate Guide to Liquidity Providing in Crypto Markets”.

For specific guides that will walk you through the process of proving liquidity on various chains and AMM protocols, check out some of these links!

APY.Vision does not give investment advice and always insists that you do your own research. Read our full Legal Disclaimer.

Check out APY.Vision!

APY.Vision is an advanced analytics tool for liquidity pool providers and yield farmers. If you’re using any DEXs, AMMs, or liquidity pools this is the tool you will need to easily track the ROI of your liquidity provider and yield farming activities. Try it now!