Anyone who’s spent time on YouTube has stumbled across titles like: “Watch this video to learn how I make 100x daily gains with DeFi.” And, while most of what YouTube’s crypto gurus preach as goldmines often turn out to be rug pull scams, shill projects that received too much hype, or poorly secured platforms that are ripe for hacking, that should not take away from the revolutionary potential of decentralized finance (“DeFi”).
DeFi technology is liberalizing access to financial services through a movement with even more potential than the digitalization of the financial industry. Before investing your hard earned cash on a project that a sponsored YouTuber promotes, we suggest first learning about some of the innovations taking place in DeFi.
In this article, we’ll introduce the key concepts driving DeFi, the opportunities of liquidity pools, and the power of compounded yields through liquidity mining.
What Is Decentralized Finance (“DeFi”)?
Decentralized finance is an umbrella term for many types of decentralized applications (“dApps”) that typically offer a direct alternative to a pre-existing traditional financial service. Most commonly, there are digital asset lending platforms, decentralized exchanges, and yield aggregators.
However, DeFi is more than dApps — it’s a movement. The goal of DeFi is to replicate traditional financial services on the blockchain, so as to liberalize global access to financial services. In a perfectly DeFi’d world, a rural farmer in India should have the same access to financial services as a banker on Wall Street. DeFi applications boast four unique traits that, in turn, have created this movement:
- Decentralization: Transactions are validated by a network of peers, meaning that all third parties are removed. As such, no transactions can be invalidated or limited.
- Permissionless: Only a wallet address and internet connection is required to participate in DeFi services. As such there are negligible barriers to entry.
- Transparency: Information regarding transactions, prices, and fees are publicly available on the blockchain.
- Immutable: Once a transaction is confirmed by a network of peers, records cannot be changed and are not threatened by user error or bad actors.
The DeFi movement has given rise to powerful technologies with the potential to shape the global financial landscape. It offers users the ability to put their digital money to work. Liquidity pools have been a particularly noteworthy innovation, through which users can exchange, lend, or stake tokens to compound their gains.
What Is a Liquidity Pool?
A liquidity pool is a collection of digital tokens held within a smart contract. It can be thought of as a bank account without one specific owner, and which is regulated and controlled by the parameters of the programming code of the smart contract. Since a smart contract is just code that runs on the blockchain, liquidity pools work autonomously and can be automated to fulfill a targeted job.
Liquidity pools are the key components across many dApps. A primary use case is to act as the secondary party in a cryptocurrency trade. To understand this, let’s take a look at how centralized exchanges (“CEX”) work compared to decentralized exchanges (“DEX”).
Centralized exchange — A CEX operates similarly to a standard brokerage that can be used to trade stocks. A brokerage uses a centralized order book system that acts as an intermediary between two traders. When one trader wants to buy an asset at a specific price, the brokerage finds a different trader that is willing to sell the same asset at the same price. The trade requires the two sides to be in agreement to be executed. If the system cannot find a counterparty at a specified price, then the trade will fail to execute.
Decentralized exchange — Instead of an order book, most DEXs use an automated market making (“AMM”) system. When a user wants to trade, the AMM pulls the asset from a liquidity pool instead of a third party counterparty. This allows the trade to execute immediately as the liquidity pool acts as the trade’s counterparty.
In order for a liquidity pool to work, it needs to have sufficient liquidity with digital assets deposited into it. Anyone can deposit digital assets into a liquidity pool, but there are certain requirements. The most common is to deposit equal amounts of two different tokens. For example, if a pool is made up of Ether (ETH) and Bitcoin (BTC), you’d have to deposit equal amounts of each coin, or $100 worth of ETH, and $100 worth of BTC. In return, you’d receive a token representing your stake in the liquidity pool, known as LP tokens. LP tokens act as proof of your deposit in the liquidity pool. When you want to withdraw your assets from the pool, you’d exchange your LP tokens to return your digital assets.
Liquidity Pool Earnings
When users use a DEX to exchange tokens, they are required to pay a small fee for each transaction. This fee is in addition to the gas fee that powers blockchain transactions and is paid directly to the liquidity pool. The proceeds from this fee is then added to the liquidity pool, thereby growing the pool in value and increasing the value of your stake. Cha-ching, liquidity mining rewards!
Most decentralized exchanges incentivize users to keep their assets locked into a liquidity pool by offering LP token rewards alongside the opportunity to stake these tokens on the platform. By staking, users lock their assets on the protocol in order to help validate transactions — similar to how bitcoin miners offer their computing power to validate network transactions. Income is typically generated through interest yields from transaction fees in the liquidity pool and earned as long as LP tokens are staked.
Some savvy investors will put their assets to work via yield farming, which involves liquidity mining and staking across various DeFi protocols in order to score the highest yields, expressed as an annual percentage rate (“APR”). This can be a sound strategy to quickly compound cryptocurrency gains; though, keep in mind, APRs can fluctuate based on demand and the amount of LP tokens in the farm. So, they’re never guaranteed and can be subject to violent swings in value.
Get the Most Out of Your Cryptocurrency
Liquidity mining, staking, and yield farming provide excellent options to put your digital assets to work. While these methods are not without risk, don’t let them stop you. Liquidity plays an integral role in DeFi, and projects continue to offer heavy incentives for users that provide liquidity. Getting in at the early stages is key to growing your slice of the investment pie, which in turn can lead to more investment opportunities and better yields down the road.
Kyoko.Finance is a DAO-to-DAO and cross-chain GameFi NFT lending market for guilds and players. Kyoko’s DAO-to-DAO lending offers liquidity to promote web3 development, while its guild-to-guild lending, P2P NFT lending, and cross-chain asset lending platforms aim to solve the most pressing issues challenging the GameFi market, including the rising cost of entry and siloed in-game assets across different blockchains. Kyoko’s metaverse will also allow Guilds to display their history, progress, and other accomplishments, while players can connect with others in a world that can be built in, developed, and sold off.
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