Guide to Crypto Farming (part 1)
This guide will be a series of articles covering next points:
- basic introduction of liquidity pools and farming (this article)
- where to start (ready)
- how to manage your rewards (ready)
- risks (coming soon)
- how to optimise your farming rewards (coming soon)
all articles may be updated with time
Introduction to liquidity pools and farming
In any market the first problem you need to solve is liquidity, for example if you go to your local market to buy tomatoes you need two things to be present on the shop:
- they have tomatoes
- they have change
A lot of times happens that you try to buy but is late and there is no more tomatoes or the merchant doesn’t have change for your note right?
So the solution is to bring enough amount of both sides of the trade into the market so both merchant and consumer can do their trade, this is called, liquidity
DEX (decentralized exchanges) follow the same pattern, but instead of tomatoes and cash you need to pool 2 tokens
When you add liquidity on platforms like Uniswap you need to think that is like putting both tokens into 2 jars, and every time there is a swap the user is taking from one jar and putting on the other one
Let’s put this on pictures:
- liquidity provider add liquidity putting 2 tokens into a pool (3000 Orion and equivalent value in ETH)
- then a user buy Orion with ETH
- Liquidity provider wants to get his tokens back
What happened here?
- when the swap happened, the supply for orion is less than eth
- this causes the price of orion vs eth to go up
- when the liquidity provide wants to get his tokens he get’s less orion and more eth
The last point explains what is called IL (impermanent loss), I don’t want to cover this as it may need a full article but I think you can get an idea:
If one token of the pool goes up in price it’s supply decreases on the pool and I can get less value than someone who was holding both tokens, this is called IL (impermanent loss)
So, why people participate on LP (liquidity pools) then?
The missing part from previous transaction is that there is a fee paid by the user, and this fee goes directly to the pool (so al the liquidity providers share this fees as profit)
In traditional CEX the fees are just earned by the exchange, in DEX is shared across all liquidity providers, it’s a more fair distribution of wealth which is aligned with the defi paradigm (decentralized finance)
But even with that it can happen that the fees are not covering full IL which leads to the next 2 points:
The longer you pool the higher the fees and less chances to enter into IL
Liquidity pool is a passive income vehicle that is worth only on long term
Now, is there a way to improve more our investment performance?
Yes, the answer is farming :), but… How it works?
The owner of one of the tokens (for example Orion) creates a program in which it release an extra allocation of one token to the liquidity providers
You need to be careful with the APY % when investing on a farm, as you will receive the rewards on a token that can change price (decreasing the daily income)
Conclusions
- Liquidity pools are a more fair wealth distribution system
- They have a risk of IL (impermanent loss)
- Fees + farming mitigate previous risk
- It’s a passive income investment and need long term to be profitable
I hope you have enjoyed this guide, what to read next?
- farming: where to start (ready for reading)
- how to manage your rewards (coming soon)
- risks (coming soon)
- how to optimise your farming rewards (coming soon)
Next article, where to start:
