HargaRumah: How to Generate Yield by Providing Liquidity

Sabtu, 14 September 2024

How to Generate Yield by Providing Liquidity - My Favorite DeFi Activity

Good morning my tasty friends, I hope you're all having a fantastic start to your weekend.

This week, I want to spend time on what's become a very popular topic here in the tastycrypto cave, and one of my favorite activities in the world of DeFi… Providing liquidity for decentralized exchange, specifically on Uniswap.

But first, let's take a look at the market.

Performance Dashboard

Finally, we've got a some green on the screen with the market experiencing a bit of a relief rally this week!

Bitcoin is flirting with 60k again, but I'm not so sure we're out of the woods, at least not yet. For more on this, see last week's email on the macro environment we find ourselves in.

We remain range bound (albeit a massive 50k-70k range) with the decelerating rate of change of growth and inflation still in the driver's seat.

Price momentum is still indicative of this environment, where regardless of the bounce into the weekend, we remain in a bearish trend. This is an environment where I think it's sensible to trade around a core position. If you were buying low 50s, nothing wrong with locking in some profits around 60.

Implied and realized vols continue to trade lower with a sense of apathy, giving us expected weekly trading ranges for Bitcoin and Ethereum of roughly $4,500 and $200 respectively.

Solana now on tastycrypto

Decentralized Exchange Explained

D ecentralized exchange (DEX) is one of the key innovations fueling the rise of decentralized finance (DeFi). Unlike traditional exchanges, where trades are facilitated by a central authority, a DEX runs on a blockchain network like Ethereum and lets users trade cryptocurrencies directly with one another, eliminating the need for intermediaries.

Instead of a central limit order book where trades are executed by matching buy and sell orders on the exchange, DEXs are powered by automated market makers (AMM). Automated market makers are smart contracts (algorithms) that automate the process of buying and selling digital assets.

Using a self-custody wallet, anyone can connect to a DEX and swap tokens on-chain. For example, if you hold ETH and want to trade it for a stablecoin like USDC, you simply connect your wallet, select the tokens, sign the transaction, and the trade is executed instantly—no intermediaries, just smart contracts.

In addition to trading, users can also participate by providing liquidity, earning yield while facilitating the exchange process. Known as liquidity providers (LPs), these users are crucial to the functioning of any DEX, including Uniswap, the largest decentralized exchange with over 13 million monthly active users and $2 billion in cumulative revenue since 2018.

I've been providing liquidity to Uniswap since 2021 and it's become one of my favorite ways to participate in DeFi. It can be quite lucrative too. In my experience, it's realistic to realize a return of anywhere between 20-30% on a yearly basis, depending on market conditions.

How Does Trading on a DEX Work?

To swap tokens on a decentralized exchange, liquidity must be available for the token pair involved in the trade. This is where liquidity providers (LPs) come in.

Anyone can provide liquidity by connecting their wallet, depositing an equal value of two tokens into a liquidity pool, and setting a price range for their liquidity.

Once deposited, users receive LP tokens, representing their share of the pool and entitling them to a portion of the trading fees that are charged by the exchange.

When users trade tokens, they do so against the liquidity in these pools. For example, in an ETH to USDC swap, the exchange taps into the ETH/USDC liquidity pool.

Smart contracts facilitate the trade by adding ETH (sold by the user) to the pool and transferring USDC (purchased) to the user's wallet. As this happens, the token prices in the pool adjust based on the new balances.

For each trade, the decentralized exchange (in this case, Uniswap) charges a small fee (usually between 0.05% and 0.3%) that goes directly to liquidity providers as a reward for supplying liquidity.

This is the incentive mechanism for providing liquidity to the exchange and LPs can then withdraw their share of the fees at any time by redeeming their LP tokens.

Creating a Liquidity Pool on Uniswap

1. First, you need a wallet and some crypto held at the wallet address you control. If you don't have a self-custody wallet, the tastycrypto app for iOS, Android, and Google Chrome will let you connect to Uniswap and provide liquidity.

If you have a tastytrade account with crypto transfers enabled, you can also quickly log in to your account within the app and easily transfer crypto to your wallet address.

2. Once you have an equal amount of crypto held at your wallet address, you then need to connect your wallet to Uniswap and access the Pool interface.

From here, you'll select the price range you wish to provide liquidity within and the amount of liquidity you'll provide. Next, you create the pool by signing the transaction within your wallet.

Buy Crypto

Providing liquidity to a decentralized exchange might seem daunting at first, but it's a fairly straightforward process once you understand the basics.

On the tastycrypto show this week, Glenn and I explain all of this in more detail while we set up a pool, live on the show.

If you missed the episode when it aired, you can watch it on the tastycrypto YouTube channel here.

tastycrypto on Youtube

Providing Liquidity and Impermanent Loss

Participating in DeFi as a liquidity provider can generate yield, but it comes with tradeoffs, including impermanent loss. This occurs when the value of assets in your liquidity pair changes compared to when you deposited them. The greater the price divergence, the higher the risk of loss.

While you earn fees from trading activity, significant price swings can result in impermanent loss, which means you'd have been better off simply holding the assets. The loss is only temporary if prices return to their original ratio, but it becomes permanent if you withdraw while prices are still off balance.

For example, if ETH's price rises, your pool's ETH balance decreases, meaning you miss out on the full price rally.

I tend to think of this as an opportunity cost associated with providing liquidity versus simply holding the asset.

In a way, it's similar to selling covered calls when trading options, where you earn premium income, but if the stock price rises above the option's strike price, your upside is capped, and you would have profited more by not selling the call.

As trades occur on the exchange, the balance of tokens in your liquidity pool will change.

For example, if traders buy ETH from the pool, your share of ETH decreases since your pool is effectively selling ETH and buying the other token of the pair to facilitate the trade.

As ETH's price rises, your reduced holding means you don't fully benefit from the price rally compared to just holding a balance of ETH.

If the price of ETH continues to rise, eventually you will have sold all of the ETH you started the pool with and the price of ETH will be above the top of the price range you initially set when creating the pool.

To better understand this, here's an example from the tastycrypto Learn Center:

Let's imagine that you are a liquidity provider on Uniswap. Here is how this situation materializes step by step in a hypothetical example:

To participate in the USDC/ETH liquidity pool on Uniswap, you need to contribute an equal value of USDC and ETH. Imagine ETH's price is $1,000 per coin. To join as a Liquidity Provider (LP), you might deposit, for example, 0.5 ETH and 500 USDC, totaling a $1,000 investment at that moment.

Across all parties invested, the pool has a total 5 ETH and 5,000 USDC, making your contribution 10% of the pool. You receive an LP token reflecting this percentage.

Should ETH's price rise to $4,000, DeFi arbitragers adjust the pool by adding USDC and removing ETH to maintain the price ratio.

With the total liquidity still represented by 10,000 LP tokens, the actual holdings shift to 2.5 ETH and 10,000 USDC in the pool.

After redeeming your LP tokens, you'd get 0.25 ETH and 1,000 USDC, now worth $2,000, giving you a $1,000 profit. However, if you had simply kept your 0.5 ETH and 500 USDC, their value would be $2,500, realizing a $1,500 profit, demonstrating the concept of impermanent loss.

Avoiding Impermanent Loss

Impermanent loss can't be avoided entirely, but risk can be mitigated, depending on your approach to the market.

1. Provide liquidity to pools with stablecoin base pairs.

When supplying liquidity to a decentralized exchange, you're inherently short volatility. To reduce this exposure, you can choose pairs with a stablecoin base, like ETH/USDC.

In this setup, you only need to manage the volatility of the ETH side, as the stablecoin remains pegged to the dollar.

2. Provide liquidity during low volatility market environments.

Another strategy is to provide liquidity for volatile cryptocurrencies as long as their prices remain stable. If significant price changes occur and the volatility regime or price trend shifts, you can withdraw your funds and remove your liquidity pool.

Keep in mind that participating in liquidity pools can be costly in high gas-fee environments, and lower volatility typically results in lower rewards.

More Resources

Like I mentioned previously, providing liquidity on Uniswap is one of my favorite DeFi activities and here at tastycrypto we're working to create even more content around this topic.

In the meantime, if you're interested in learning more about decentralized finance and its key concepts, you can find more articles using the link to our learn center below.

Learn DeFi

Stay tasty,

Ryan