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Liquidity provision and yield farming in decentralized finance (DeFi) are critical to understand. Liquidity provision is the backbone of DeFi, allowing for token swaps, loans, and composability of complex DeFi instruments. Yield farming allows users to earn the higher yields and rewards for which DeFi is known. But both concepts come with risks that are important to know before participating.
Let’s look at liquidity provision and yield farming in detail, how they work, their risks, and how you can more safely use these tools to participate in DeFi.
This article should help prepare you for Wave 5 of Linea’s DeFi Voyage.
Liquidity provision means supplying your assets to the liquidity pools of DeFi protocols in return for fees and rewards. These liquidity pools are essential to the operation of DeFi. Similar to traditional finance—where the money in your savings account allows the bank to lend to others—liquidity provision allows DeFi protocols to use your funds so that other users can swap, lend, and borrow. Liquidity provision is the backbone of DeFi.
When you become a liquidity provider, you can pick single-sided or dual-sided pools.
Dual-sided liquidity provision means depositing two different asset types into a single liquidity pool, often in equal value. For example, you might deposit $500 worth of ETH and $500 USDC into an ETH/USDC pool on an AMM. You supply liquidity for other traders to trade their USDC and ETH for one another. Be aware, though, that dual-sided liquidity risks impermanent loss (explained below).
In single-sided liquidity provision, you deposit only one asset type into a pool or protocol. For example, you might deposit USDC into a protocol that lends out your USDC and rewards you with interest.
Yield farming is using a variety of investing tools and strategies (such as liquidity provision) to generate the highest possible returns on your crypto assets. On some protocols, you may lock your assets for some time. On others, you may deposit your assets into a single-sided liquidity provision so that the protocol can lend your assets to other users. (See this previous article on lending and borrowing for more details.) On yet another, you may participate in AMM liquidity pools. In all cases, you expect to earn rewards.
Yield farming is similar to investing in various traditional finance options such as money market accounts, bonds, and more—but with several key differences.
First, in yield farming, you frequently move your assets from protocol to protocol, chasing the ever-changing best returns. Because DeFi is decentralized and your wallet controls your funds, moving among protocols is fast and easy. Yield farmers might change their strategy and the protocols they use multiple times per day, or even per hour, as interest rates change.
Yield farmers accept the risk of these protocols and the frequent moves between protocols in exchange for higher returns.
Second, the rewards you earn are not just interest or fees. Sometimes, you earn the governance token of that protocol. You may even earn all three—interest, fees, and the protocol token!
Third, yield farmers stack DeFi protocols, combining several strategies to earn multiple tiers of interest on the same asset. As a simple example, you might:
Stake 1000 USDC as a single-sided liquidity provision on a money market, such as Mendi Finance or LayerBank.
In return, the protocol gives you 1000 synthetic tokens representing your staked USDC.
In DeFi, you can trade and sell these synthetic tokens representing your staked tokens.
You deposit the 1000 synthetic tokens into a pool on any Dex available.
You are now earning interest on your stake in Mendi Finance, and you are earning fees and rewards as a liquidity provider for the dex that you are using, all from the original 1000 USDC token.
Yield farming can quickly become complicated. Yield farmers are constantly searching out new protocols and new ways to stack the protocols to earn a maximum yield on their assets.
Yield farming and liquidity provision have been critical to the development of DeFi. By providing liquidity to the ecosystem, they give protocols—especially new ones—the funds to operate and a way to distribute their protocol tokens widely.
They also give users a way to earn returns on crypto assets that would otherwise be idle.
So where can you participate in these protocols? Linea is ideal for providing liquidity and yield farming. It’s an L2 faster and cheaper than Ethereum, allowing you to try out, move, and combine protocols cost-efficiently.
Some examples of protocols on Linea include Velocore, Echo DEX, Vooi, iZiSwap, Syncswap, MetaVault, DODO, XFAI, Deri, LogX, Toaster, Clip Finance, Steer, Yasp.fi, Sushi, Standard, and Lynex.
Before you decide to participate, it is important to understand the potential risks.
One of the most important (and perhaps most complicated) risks with providing liquidity is impermanent loss. Impermanent loss happens when the value of your assets deposited in a liquidity pool ends up being less than the value of the assets had you simply held them. This loss is a result of the unique way that AMMs work. Let’s look at an example:
You deposit 1 ETH (worth $1,000) and 1000 USDC into a USDC/ETH pool for a combined value of $2,000.
At the time of deposit, the ratio in the pool is the market rate: 1000 UDC to 1 ETH.
After your deposit, there is a total of 10 ETH and 10000 USDC in the pool ($20,000 total liquidity)—so you end up with a 10% share.
Over time, while your assets are in this pool, the value of ETH rises to 4000 USDC.
Arbitrage traders add USDC to the pool and take out ETH until the ratio reflects the new market value of ETH 4000 USDC to 1 ETH.
The pool now has 5 ETH and 20000 USDC.
You decide to withdraw your assets.
You get back your 10% share of the pool, which is now .5 ETH and 2000 USDC.
Your assets are now worth $4,000—double your original $2,000!
But not as much as the $5,000 you would have if you had just held the original 1 ETH and 1000 USDC.
It is key to understand that impermanent loss can happen regardless of whether prices rise or fall. It is not the price but the ratio between the prices of the two assets in the pool that is key. The more that ratio changes, the higher the impermanent loss. If both assets go up (or down) equally, and the ratio stays the same, you won’t incur impermanent losses.
These losses are called impermanent (even though they can very much be permanent) because you don’t technically have a loss until you withdraw your assets, giving you the option to keep the assets in the pool in the hopes that the ratio returns to where it was when you deposited your assets.
Yield farming also comes with risks. Oversized returns can be exciting, but of course, along with these higher-than-traditional returns come higher-than-traditional risks. If you decide to participate, you should know some of the most important.
First, crypto markets have high volatility. The value of the tokens you farm and of the tokens you earn can fluctuate wildly. Locked tokens can lose significant value by the time they are unlocked. Rewards earned can be worth significantly less by the time you sell them.
Second, yield farming involves complexity risk. This is new technology, new protocols, and often unproven code. And the mechanism behind yields can be complicated. By stacking multiple protocols, you assume the complexity risks of each protocol, combining those protocols, and your stacking strategy itself.
Finally, the impermanent loss explained above can quickly cause your stacked strategy to fail.
So, how do you mitigate these risks?
First, you should research and understand protocols before you participate. Because the strategies and protocols can be complex (and are often new models created by anonymous teams), you want to be sure you understand the yields, where the yields are coming from, how long your tokens are locked, in what situations impermanent loss (or other losses) might occur, and what unique risks exist. Read the documentation, join the Discord group, and take the time to fully understand the protocol.
Second, hedge your strategies. Spread your risk by learning about and using multiple protocols and strategies so that you aren’t risking all of your assets on one platform. Learn about basic investing concepts—diversification and asset types—and crypto-specific concepts such as stablecoins and AMMs.
Liquidity provision and yield farming are two of the basic and most important concepts in DeFi. They have their share of risks, but by taking the time to understand them, you can take advantage of their benefits and actively participate in the new world of DeFi.
Try out liquidity provision and yield farming with Linea’s DeFi Voyage>
The associated tasks will be open between December 4th to 13th.
Bon Voyage!
Linea.Build
