Decentralized Finance (DeFi) offers the opportunity for all crypto-currency holders to put them on the line. In addition to lending strategies, Liquidity Providing presents itself as a new tool to save in a secure way.

The role of an exchange

Before the advent of Decentralized Finance, crypto-currency investors used centralized exchanges - also called CEX for Centralized Exchange - managed by a company. The most famous ones being Binance or Coinbase. Their role is to act as an intermediary between buyers and sellers who exchange assets. The price of the assets is dictated directly by supply and demand and is set once the buyer and seller agree.

Decentralized Finance has allowed the development of decentralized exchanges - DEX for Decentralized Exchange - on which movements are made without the intervention of an intermediary. By removing this external assistance, users regain full control of their funds. Exchanges can be represented as a peer-to-peer contract operating through a pool of funds deposited on the blockchain. These pools of funds are called liquidity pools.

The operation of liquidity pools

Each pool consists of a pair of tokens (A and B). They are split evenly 50-50 to allow users to convert their A assets to B; and vice versa. Thus, in order for a buyer to purchase A assets, there does not need to be a seller of B assets at that moment, but only sufficient liquidity of B tokens in the pool.

These pools are fed by liquidity providers, called Liquidity Providers. Their job is to deposit A and B tokens into the pool. Anyone with a pair of evenly distributed chips can then become a Liquidity Provider to earn passive income. In effect, as soon as an individual exchanges assets A for B and vice versa, the Liquidity Provider will earn a commission - like dividends.

Investors wanting to gain exposure to Liquidity Providing will need to select pools where both crypto-assets are stablecoins. Let's take the example of the PancakeSwap protocol, one of the most reputable DEX. For its pool consisting of the stablecoins USDT and USDC, the Liquidity Provider will have to deposit 50% USDT and 50% USDC. In exchange for his liquidity contribution, he receives LP tokens (acronym for Liquidity Provider). They are distributed in proportion to the amount of liquidity held in the pool, like shares in a company. These LP tokens correspond to the proof of deposit of the liquidity on the Blockchain. They are therefore necessary to recover the crypto-assets deposited in the pool.

Remuneration of Liquidity Providers

When a user of a Decentralized Finance protocol wants to convert his crypto-assets against others, he is charged a transaction fee. As an example, these fees amount to the tune of 0.2% on PancakeSwap. Of this, 0.17% is paid to LP token holders; the remaining 0.03% is retained by the platform's development team.

Since the compensation of the liquidity providers depends on the trading volume of the pool and the liquidity in it, the return is variable. The higher the volumes compared to the liquidity in the pool, the higher the compensation for the Liquidity Providers. Let's take an example where a pool contains the equivalent of $1,000,000 in crypto assets. If the trading volume over the last 24 hours is $500,000, then the daily commission for all Liquidity Providers is $500,000× 0.17% = $850. A user who injected $1,000 into this pool would therefore own 0.1% of the LP tokens. He could then claim a gain of $850 × 0.1% = $0.85 over the past 24 hours, or an annual return of 31%.

What are the risks?

The major risk when providing liquidity to decentralized exchange pools is that of impermanent loss. This occurs when the price of one of the two assets fluctuates significantly in relation to the other, either up or down. When the Liquidity Provider wishes to remove its cash from the pool, it may recover less value than if it had simply kept its assets out of the pool and allowed them to appreciate or depreciate over time.

To illustrate this risk of impermanent loss, consider the example of a Liquidity Provider who deposits $500 USDT and 1 BNB (where 1 BNB = $500 on the day of deposit). His total deposit therefore has a value of $1,000. If the BNB price were to rise to $750, the pool would be subject to an increase in demand for BNB and a decrease in demand for USDT. The cash provider would then be in possession of a pool with a total value of $1,000, but allocated in a different way. Now, if he had kept his crypto-assets out of the pool, he would have $750 in NBB and $500 in USDT, or $1,250. So that $250 difference is the impermanent losses.

However, an investor looking for a stable return can protect himself against this risk of impermanent loss. Since the latter is only related to the volatility of the deposited crypto-assets, the liquidity provider will once again be well advised to expose himself only to pools composed of stablecoins, whose value does not fluctuate.

The data and figures in this article are provided for information purposes only and in no way constitute investment or tax management advice.