DeFi brought in a new way of earning passive income through liquidity provision. In fact, a liquidity provider earns from liquidity mining, also called yield farming. This is because decentralized exchanges require liquidity in order to meet their mandate of converting one cryptocurrency to another.
Therefore, these decentralized exchanges (DEXs) pay rewards to people who provide liquidity to their platforms. The rewards are an incentive for users to bring more liquidity to their platforms. In simple terms, liquidity is the ease with which an asset can be turned into real cash.
However, In DEXs liquidity also entails how easy it is to convert one cryptocurrency to another. If an exchange has liquidity problems, it takes a very long period to convert cryptocurrencies. For example, it could take 48 hours to convert BTC to TRX.
What is a liquidity provider?
A liquidity provider is an individual or organization that funds an exchange by providing two cryptocurrencies. The two cryptocurrencies form a pair, such as BTC/ETH. The person should stake two cryptocurrencies with equal values. Usually, the values are denominated in the United States dollar or any other major currencies.
An example of liquidity provision
Let’s say John wants to be a liquidity provider of the TRX/USDT pool. He should provide TRX and USDT with the same value, if denominated in US dollars. The quantity of each token, TRX or USDT, depends on the rate at the time of making the transaction.
For instance, if John wants to invest $2,000 in liquidity provision, for the TRX/USDT pair, he buys TRX worth $1,000 and USDT worth $1,000. After that he performs the formalities which the exchange requires. In return, the exchange provides John with LP tokens confirming his position in the pool.
Farming liquidity pools (LPs)
The liquidity provider (LP) tokens are a proof that someone has invested in a pool. An investor holds on the LP tokens until he redeems his invested cryptocurrencies. During the interim period when one holds these tokens, he/she can stake them and earn some rewards. However, this depends on the provisions of each exchange.
How do liquidity providers earn money?
There are two major ways in which liquidity providers earn passively. They earn fees generated from trading activities of the pair they invested in. The exact amount of fees each liquidity provider gets is in direct proportion to his/her investment in the pool. Therefore, the more one stakes the more he/she earns.
Staking the LPs tokens: Some pools allow users to stake their LP tokens and earn more rewards. Above this, some exchanges offer their clients governance tokens based on their investments.
There is also a subtle way you benefit from investing in pools. When you hold your specific cryptocurrencies in pools, you benefit from their appreciation. Since, people are free to redeem their tokens at any time, they can do so when their values are high. Thus, liquidity provision is an alternative to the Hodling strategy.
Liquidity provision is one of the newest ways of earning passively in the crypto space. However, in order to benefit the most, one should invest in a pair with high demand, such as Ethereum-USDC liquidity pool on Uniswap.