Yield Farming Chapter Four - Liquidity Pools
This is Chapter Four, focused on Liquidity Pools, in a series of articles that will be released about yield farming. The purpose of this series is to introduce the concept of yield farming to those who are unfamiliar with it, then move into various yield farming strategies and finally step-by-step walkthrough of the process. I hope you enjoy the series and any feedback you have would be greatly appreciated.
Chapter Four - Liquidity Pools
Liquidity (noun) the availability of liquid assets to a market
Pools (noun) the funds from many individual investors that are aggregated
A Liquidity Pool (LP) is a collection of cryptocurrency coins or tokens that are locked into a smart contract that is used to allow for trades between the underlying assets (pair of coins) on a decentralized exchange (DEX).
What is a Liquidity Pool?
Liquidity pools (LP) serve a critical function in decentralized finance (DeFi) and are the key ingredient of an automated market maker (AMM). The LP is the liquidity, or capital, within the AMM that allows swaps (trades) to be made. This means the coins or tokens within the pool can be exchanged for one another. The LP tokens are the backbone of yield farming and holders of LP tokens are rewarded by providing the liquidity needed to perform swaps.
The liquidity pool is simply a bunch of coins or tokens kept together. Think of a liquidity pool in terms of the US dollars and the British pound, in order to exchange from one to another you have to go to a bank that holds both currencies. In this scenario, the bank is functioning as the AMM while the collection of dollars and pounds the bank holds is acting as the liquidity pool. The bank teller is like the "smart contract" that does the exchange from one currency into the other. Unlike a bank, you can create LP tokens anytime of day on any day, no bankers hours here.
How do you create a Liquidity Pool (LP) token?
Most LP tokens consist of two coins or tokens, however, some may consist of three or more which is much rarer. In order to create a LP token, you must first own both of the underlying tokens. For example, if you wanted to own a LP token consisting of Bitcoin (BTC) and Ethereum (ETH) you would first need to own both BTC and ETH. Since LP tokens are created with the same amount of value of each token, you would need to hold an equal value of both BTC and ETH.
The BTC and ETH coins can be bought on an exchange and stored on a wallet like MetaMask. When you are ready to create your LP token you can combine them into LP tokens on an AMM. If you only hold one of the coins, you can also go to the AMM and swap half of the one you hold for the other tokens before combining them into the LP tokens. Regardless, once you hold the LP token you can place them into a yield farm thus providing liquidity and begin to earn rewards in terms of an annual yield or percentage return on the LP tokens.
If BTC cost $40,000 and ETH cost $4,000, you would have to have ten times the amount of ETH coins to pair with BTC to create your LP tokens. Once you create your LP tokens they must always remain at a 50/50 value balance so the amount of underlying BTC and ETH coins will shift over time away from the 10:1 ratio you started with based on the price movement of each coin.
How do you earn rewards for holding LP tokens in a yield farm?
Once LP tokens are placed into a yield farm you become a liquidity provider and your LP tokens earn yield based on the percentage of the overall pool you hold. The yield is primarily derived from transaction fees generated through the swaps of the underlying coins or tokens within the AMM. The annual returns fluctuate based on the number of swaps being performed.
Let's say your BTC/ETH LP tokens are in a yield farm and your tokens equal 0.005% of the pool's overall value. This means you will receive 0.005% of the income generated within that liquidity pool on the AMM. So if the pool generates $50,000 in fees in a day, you would receive $250 worth of coins ($50,000 * 0.005%). The $250 in rewards can be paid out in a number of ways but are often paid out in the AMM's native coin or possibly one of the underlying coins in your LP token. You can take out, or harvest, these rewards or compound them back into LP tokens to increase future rewards.
Returns in yield farms can range from small percentages in the single digits annually to 1,000% or more for riskier investments often containing new and volatile tokens. Most yield farms have returns in the double digits annually, however, triple digits are not uncommon either. The greater the risk, the greater the return.
The smaller the overall liquidity pool in total value, the larger share you will hold and the more price movement in the underlying coins will be seen with token swaps within the pool. The larger the pool, the smaller percentage you will hold overall and the less price movement in underlying coins will occur due to swaps.
Costs associated with Liquidity Pools and Yield Farming
Please note, transactions within an AMM including creating LP tokens, placing them into yield farms, along with collecting or compounding tokens all come with associated "gas fees" which are the transaction fees associated with each action. The amount of gas fees you pay are determined by which network the AMM sits on as well as the amount of activity currently happening on the network. The higher the activity, the higher the fees. Also, expect to pay a fee to the exchange when first buying your coins as well as transferring the coin(s) to your wallet. As mentioned, there are fees for creating the LP tokens in the form of gas fees and "slippage" which is a percentage you pay when creating the LP token which also varies based on what AMM you are using.
Because you will be paying the fees above and fees each time you collect or harvest your rewards, it is a good idea to keep a decent amount of the token that used to pay the fees within your wallet. This token is generally the main native token of each network so Ethereum (ETH) on the Ethereum network which can have expensive transactions or lower fee networks such as the Binance Smart Chain network using it's BNB Coin or the Polygon network which uses its MATIC coin as examples.
Whiteboard Crypto YouTube Video - What is a Liquidity Pool
Previous Chapters
Yield Farming Chapter One - What is Yield Farming?
