DeCentralized Finance: a short introduction to being a Liquidity Provider.
Decentralized Finance terminology.
I was explaining Cubfinance to a new investor, and I realized by the glazed look in their eyes that I had lost them. So I back tracked in our conversation to the last point they fully understood. I realized there were so many things we assume people understand when we describe or explain decentralized finance, that we don’t explain it well. In order to help those new to defi I would like to explain a common term; liquidity provider.
The definition of being a Liquidity Provider, is an individual who deposits dollar equivalent amounts of two assets into a trading pair on an exchange. In return this individual earns a share or percentage of all transaction fees paid by traders who use the trading pair. These sentences sound simple, but actually describe several processes which aren’t revealed at all by those words. So let’s break that sentence down and explain its components.
This means there are enough quantities of two assets in a tradition pair, that individuals who want to trade one token for another will be able to do so.
you want to trade Bitcoin for Ethereum. You have one Bitcoin and you want to trade it for ten Ethereum. This means there is enough Bitcoin and Ethereum deposited in the trading pair for you to be able to trade your one Bitcoin for ten Ethereum.
You have ten Bitcoin and you want to trade them for 100 Ethereum. There has to be enough Ethereum deposited in the trading pair for you to trade your Bitcoin for 100 Ethereum. If there wasn’t at least 100 Ethereum deposited in the pool your trade wouldn’t go through. You might have to go to another exchange that has enough Liquidity that such a large trade is possible.
Dollar Equivalent Pairs
The next word you need to understand is the term dollar equivalent. It is easy to understand, once someone explains it to you. But the words by themselves don’t give enough information for you to know what to do. I think this is best explained by an example. In this example I will not use the true price of Bitcoin and Ethereum to keep the math simple, so you can focus on the concept, not the math.
If Bitcoin is worth 4000 dollars USD and Ethereum is worth 400 dollars USD, then one Bitcoin valued at 4000$ would be worth ten Ethereum worth 400 dollars USD.
So in order to deposit a Dollar Equivalent Pair, you will deposit one Bitcoin and Ten Ethereum in the Liquidity Pair. Thus the dollar value of one Bitcoin $4000 is matched by the dollar equivalent of ten $400 Ethereum, which is $4000.00 dollars.
It’s the ratio not whole numbers.
Fortunately you don’t need a whole Bitcoin or a whole Ethereum, just a ten to one ratio in value. So you could have 1/10th a Bitcoin or 0.1 Bitcoin and 1 Ethereum.
If we were doing one dollar Leo and one hundred dollar BNB, we would deposit 100x1$ Leo and 1x$100 BNB, so the value of 100 Leo $100, matches the dollar vale of 1 BNB $100, so they are deposited in this proportion.
Liquidity Providers and Smart Contract
When you deposit your assets into a Liquidity Pair on a decentralized exchange you aren’t depositing it into the exchange cryptocurrency wallet like you do on a centralized exchange. You are depositing the assets into a smart contract. This effects how you do things. This means you connect your wallet to the website, and give the website permission to access funds in your wallet. Then you transfer your assets into the smart contract.
There’s no human involved at this point, so your trusting the code to protect your assets. Because it’s code and no human, it’s considered Trustless, as in your aren’t trusting another human with your cryptocurrency,
In the example above, where for simplicity, I said if Bitcoin was worth $4000.00 and Ethereum was worth $400.00, a Dollar Equivalent Trading Pair would contain One Bitcoin to Ten Ethereum. So if you wanted to provide Liquidity to a Trading Pair on a decentralized trading exchange, you would need to possess both Bitcoin and Ethereum in a ten to one ratio. Fortunately you don’t need a whole Bitcoin or a whole Ethereum, just a ten to one ratio in value.
How do you earn money? Transaction Fees
Those of you who buy and sell stocks, bonds, options, etc are familiar with Commissions: the fee you pay for the Stock Broker to make your trade. In fact Commissions are the most lucrative thing about being a Stock Broker. An exchange like the New York Stock Exchange or American Stock Exchange collects Commissions on literally millions of trades every day. But you need to have millions of dollars to be a Stock Brokerage, so you can collect those fees. Plus their are exams, certifications and regulations.
In cryptocurrency, decentralized exchanges only require you to bring dollar equivalent pairs and you start earning commissions on trades, but only in decentralized finance commissions are called transaction fees.
Percentage of transaction fees
If you provide 1% of the liquidity for a trading pair, you earn 1% of the trading or transaction fees every day that your deposited assets represent 1% of all deposited assets. It is helpful to look at an example.
The trading pair WLEO-ETH
You deposited 1 ETH and 10,000 WLEO.
Your deposit represents 1% of all the ETH-WLEO in that pool. The transaction fees for the day are $100, so you earn 1% or 1$.
Calculating Return on Investment
Percentage of transaction fees
In the above example, our hypothetical investment of $2000.00 was earning us $1.00 per day, and it sounds small. Now while that doesn’t sound like a lot, it was based on a very small amount of transactions, $100 per day. To be honest, that’s very, very small, and transaction volume is usually in the tens of thousands or millions. Let’s play with some examples. Same amount deposited, one ETH and 10,000 WLEO. So if transactions go up from $100 to $1000 per day, it’s $10.00. If transactions go to $100,000 it’s $1000 dollars.
Now look at Return on investment
So your $1000 worth of ETH and $1000 worth of WLEO could make you $1.00/day or $365/year, or a return on investment of 365/2000, or 18.25% per annum. Or if it’s $10/day, it’s 3650/year and a return on investment of 3650/2000 or 182.5%.
So now compare this to savings accounts offered by banks of 1-2% interest per year, or returns in the stock market of 5-15% per year. Now you understand why money is being invested in decentralized finance at an ever increasing rate.
While Providing Liquidity is profitable, it is not always safe, as hacks and exploits, are not uncommon and cause the loss of all your trading capital. It’s important to use trusted projects, which have existed a while or audited by reliable parties, like CertiK.
It’s also important to deposit your money with people who are identified by name, picture and who are well know, to reduce the risk of them running off with your money.
That’s the reason many investors on Hive have invested in Cubfinance, safety: known creator, and audited project. Link to Cubfinance.
If you are careful, DeFi is safe, and lucrative. The earnings are the reason it is attracting investors from outside of cryptocurrencies usual ranks, and it has resulted in billions of dollars moving into DEFI this year.
So if you wanted to earn money without selling your cryptocurrency, you could become a Liquidity Provider on a decentralized cryptocurrency swap exchange, like Uniswap or Pancakeswap or Cubfinance.link
If you become a Liquidity Provider, the platform pays you a percentage of all the transaction fees for swaps or trades done that day, for the trading pair you provide liquidity for. As long as there’s lots of transactions or large monetary incentives being a Liquidity Provider can be very profitable.
If you came here from my Marc Cuban Article click this link to get back there. Link
@shortsegments is a writer focused on cryptocurrency, the blockchain, non-fungible digital tokens or NFTs, and decentralized finance. Read more articles by @shortsegments here: https://leofinance.io/@shortsegments
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