Cryptocurrency Liquidity Provider
12.05.2022 • Просмотров:

Cryptocurrency Liquidity Provider

By Decimal

Judging by the pace of development of the industry, DeFi will continue to serve as the basis for other innovative financial products, which will become even more complex as they strive to generate the maximum possible income, and cryptocurrency liquidity providers occupy far from the last place in this.

The rapid popularity of Liquidity Provider allows us to conclude that the complexity of DeFi is not too much of an obstacle for many.

But before we start considering what a liquidity provider is, let’s remember what decentralized finance is.

Decentralized Financial System – DeFi

Until now, we lived in the world of CeFi – centralized finance, with its banks, stock markets, where only insiders, that is, bankers and brokers, could be market makers.  DeFi is a decentralized alternative, central authorities are no longer needed to participate in the global market.

Now, in theory, a decentralized structure and, accordingly, technologies take on all the classical roles of the financial system. In fact, according to the description of the Bitcoin project on Coinmarketrate.com, it is already DeFi. It’s just that it cannot yet perform complex smart contracts and protocols that take over the classic functions of the bank.

It’s not that this is impossible in principle on Bitcoin, it’s just that the blockchain will take up a lot of memory very quickly, and the cost of transactions (Tx fees) will increase dramatically. As a result, decentralization will also suffer, since not everyone will want to run a node with several terabytes of data. Moreover, the synchronization duration may exceed the critical point, so that new nodes will no longer be able to synchronize.

At the second level, there are other blockchains and solutions that can take on these tasks better. Currently, DeFi is experimenting with all the blockchain technologies that we have seen so far: smart contracts, Lightning N., atomic swaps, sidechain, dApps, etc.

Decentralized exchanges (DEX) are a suitable example of DeFi here. Some blockchain-based DEX, for example, on Ethereum, always require transactions on the blockchain to complete a transaction, while several smart contracts can be launched sequentially, which significantly increases the “weight” of the transaction (the required memory on the blockchain), and hence the fee.

The advantage is that users remain the owners of their private keys, so there is no KYC or AML, and P2P trading is pseudonymized or even anonymous.

High fees and the duration of the Tx confirmation are the reason for the unpopularity of using some DEX. Therefore, traders prefer central exchanges, where their bots can also make cheap trades in a fraction of a second.

Decentralized applications, i.e. blockchain technologies and protocols, make it possible for the first time to lend and borrow P2P money, this is also called peer-to-peer lending. A person who borrows money has to deposit a certain amount, which is then frozen using smart contracts. If the condition in the smart contract is met, for example, if the amount falls below a certain price, the frozen amount is automatically paid to the lender.

Thus, with P2P lending, there is a risk not only that the smart contract is faulty, but also manipulation of the base price of sc, which can lead to its triggering.

For example, it may take a decade to decentralize the global stock market. The key term here is tokenization. Here, goods and even people will be linked to digital tokens and become the subject of trade. Isn’t this the dystopia we’re heading towards? There is no doubt that DeFi will become a challenge to the traditional financial system and governments!

Stablecoins

DeFi is also some stable coins that are controlled by the DAO, i.e. dApps and smart contracts.

Of course, banks can also change their business model and offer their customers DeFi products without the ultimate ownership of private keys by customers. This begins, for example, with the fact that the bank receives a license to store Bitcoin.

The hype around instant DEX on Ethereum has shown that DeFi is still in its infancy. If you want to understand the difference between Suschiswap and Hotdogswap, you will have to spend a lot of time researching. Be careful, there are many financial pyramids among the many new projects. It is often difficult for beginners to realize this.

DeFi and cryptocurrencies in general are developing so fast that even experts find it quite difficult to keep track of the entire crypto space. It probably makes sense that they just can’t get into the whole thing because of the flow of information.

And so, now it’s time to talk about liquidity providers.

 Liquidity Provider as an important part of DeFi

A Liquidity Provider, or Liquidity Provider, is a DEX user who adds funds to the liquidity pool using tokens belonging to him.

The user adds liquidity to the pool using their own cryptocurrencies or tokens on the platform, for which they receive passive income on their deposit.

Liquidity pools are an integral part of decentralized exchanges, as they are used for an automated system of market makers, providing liquidity on peer-to-peer exchanges and limiting the effect of slippage.

Instead of using a typical system based on the order book, as on centralized exchanges, funds are received from other users here. There is no longer a need for a central organization to provide all cryptocurrencies in order for there to be liquidity for the pair.

Another advantage is that when trading illiquid pairs on exchanges based on order books, buyers and sellers may suffer from greater slippage or inability to execute.

This does not happen in pools that have sufficient liquidity to complete the user’s transaction, which is provided by others, just like the user, seeking to return their funds.

For this reason, liquidity providers are treated as intermediaries and receive part of the commissions that are realized in this pool.

The amount they receive for their “service” is determined by the percentage of liquidity contributed by them. When they do, they usually have to deposit two different assets that facilitate the exchange between these two pairs.

For example, a liquidity provider can deposit $1,000 into ETH and another $1,000 into a stable cryptocurrency pegged to the dollar, such as DAI.

Thus, each transaction of the ETH/DAI pair that is performed in this pool brings a reward for the service provided.

Profitable Farming and Liquidity Provider

Decentralized exchanges (DEX) in the DeFi ecosystem minimize or eliminate the need for intermediaries to conduct trades through the use of liquidity pools. Investors in these pools are liquidity providers who, in exchange for their funds, receive profitability through so-called profitable farming.

As a liquidity provider, you are waiting for the seeds you planted (funds) to be collected (yield). Hence the name – profitable farming. The profit you get is the commission that users pay for trading in this pool.

As we can see, liquidity is very important for investors and traders, as it allows them to quickly enter and exit positions, eliminating potential negative consequences, such as slippage.

In the end, everyone benefits from increased liquidity. Spread and costs are decreasing, and asset prices are stabilizing.

The Importance of the Liquidity Provider

Asset liquidity is very important in the markets, but even more important for decentralized financing. You allow asset trading. Thanks to the added liquidity, the asset can be quickly converted from one currency pair to another at any time.

The benefits of this service:

  • LP TOKENS

LP tokens or liquidity tokens are tokens that DEX provides to liquidity providers. They are good because they can be exchanged between tokens of various DeFi platforms.

As a result, we get tokens that allow trading between platforms, creating an opportunity for investors to transfer and put these LP tokens into various DeFi solutions to make a profit.

  • Passive income

The liquidity provider receives a profit from each transaction (commission) that is made in the liquidity pool.

For example, in the case of Uniswap with ETH/DAI, we receive 0.3% of each transaction that is made on the platform. This is what in the past was known as the extraction of liquidity, and now has turned into profitable farming.

  • Asset security

We also benefit from the security of funds provided by DEX. Decentralized financing means that, thanks to smart contracts, assets do not have to be held by a third party, so we have full control over them.

Assets and tokens are stored globally, so it is very difficult for a hacker to attack a wallet and steal what investors have invested in it, as it can happen with a wallet of a centralized exchange.

Risks associated with the activities of the liquidity provider

However, not everything is so good in this world. There are also a number of risks that need to be taken into account when considering the use of this type of investment.

First, we need to be careful with the platforms we use, because while smart contracts can be very secure, they can also be prone to programming errors. It is best to look for reliable and reputable DEX.

There is also a very common risk in the world of DeFi, which is called non-permanent loss. An event that occurs when one of the assets in the pool changes its price.

If both currencies in a pair change in price in the same proportion, then nothing will happen, but when only one of them changes in price, or both change in price differently, then we can incur these losses.

In this case, there is little that can be done except to choose stable pairs, and that the possible losses are compensated by the gain from profitable farming.