The new frontier for making your cryptocurrencies profitable

LP, for us boomers, means long playing, or a 33 rpm vinyl. But in the world of decentralized finance, LP has a very different meaning: liquidity provision, or supply of crypto liquidity to decentralized exchanges, happy to remunerate your possible generosity with other crypto.

The decentralized exchanges (or DEX, as I will call them from now on) are like the centralized ones (Binance, Coinbase, in Italy Young Platform, etc) but compared to the latter they do not have a headquarters and a real company: they exist directly on chain. They are in effect software and nothing more. The most important of all is Uniswap, which has recently come to transact the equivalent of over a billion dollars worth of crypto a day.

Operating exclusively on the blockchain, DEXs cannot, even if they want to, exchange your euros for a crypto. For that there are precisely the centralized. Consequently, on DEXs each transaction is in effect a swap, an exchange between two digital currencies, for example between Bitcoin and Ethereum or between one of them and a stablecoin.

Why do people prefer DEX more and more? Essentially because, by operating only on chain, they are very safe and then because they generally offer very good trading values. They can be attractive in these values ​​also because the fee they apply for each transaction is rather low: for example Uniswap applies 0.30%. They can afford it because they don’t have hundreds or thousands of mouths to feed: they are software.

Now, like centralized exchanges and stock exchanges, DEXs also need liquidity to function, that is, to bring supply and demand together: if I want to sell a specific crypto (or stock, on exchanges) and you want to buy it, or there we meet in the same thousandth of a second on a shared value, or the transaction does not happen. This is why the provision of liquidity is such an important factor in the markets, to the point that there is a real professional figure, called a market maker, who has always carried out this task: real companies that provide huge amounts of liquidity to the exchanges in exchange. of interest (the same, more or less, for centralized exchanges).

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But with the advent of DEX, everything changes and the figure of the market maker is democratized: today everyone can be, providing their crypto to a DEX and receiving a certain fee in exchange, always in crypto. But it’s not that simple.

Meanwhile, since each transaction is a swap between two digital assets, it is necessary to participate in dual liquidity pools, consisting of two cryptocurrencies. Imagine them as a basket where there are, for example, Bitcoin and Ethereum. If I want to buy the former by paying with the latter, the software will deposit my Ethereum in that basket, withdrawing the Bitcoins. As a result, the quantity of the two cryptocurrencies is constantly on the move: the more Bitcoins are purchased by paying in Ethereum, the less Bitcoin and the more Ethereum there will be in the basket.

To “enter the basket”, therefore, the two digital currencies of which it is composed are deposited and an LP token is obtained, or a liquidity provision token, whose price is? a combination of the prices of the two underlying assets. For example, the price of the ETH-BTC token LP is? a combination of Ethereum and Bitcoin prices. If Ethereum is + 10% and Bitcoin is + 5%, can it be done? wait for the price to vary? by a percentage between 5 and 10%. It will be closer to 5% if the “basket” contains more Bitcoin at that time, or to 10% if there are more Ethereum in the basket at that time, but still such as to guarantee diversified exposure to both assets.

Once in the pool, our cryptocurrencies immediately begin to “work”, receiving in exchange their share of the fees (for example 0.30% of Uniswap) that the DEX receives from those who use it. It is therefore a sustainable remuneration, very transparent and not undermined by questionable marketing operations (exaggeratedly high fees to attract customers).

To provide liquidity to the DEXs, therefore, you must already own the cryptocurrencies, so you must send them to an on-chain wallet such as Metamask and from there buy the LP tokens of a DEX pool. It is also necessary to decide the price range of the two cryptocurrencies within which we want the software to use our liquidity in exchange for compensation, for example Bitcoin between 18 and 23 thousand euros, or between 5 and 50 thousand: the more the range is the smaller the fees will be, but the less chance our liquidity will be used. You have to be very experienced to define an optimal range.

Finally, we must pay attention to what is called “impermanent loss”, or momentary loss. Since, as mentioned, in DEX transactions are an exchange (Swap) between one crypto and another, the pools are dual. Let’s imagine them as baskets of apples and pears. A customer arrives who wants to sell pears to buy apples: will the DEX smart contract deposit the pears that the customer wants to sell and pick up? the apples the customer wants. In fact, therefore, if apples are more sought after on the market, there will be less in the basket (people tend to sell pears to buy apples). If one has entered the liquidity provision mechanism? with a mix of apples and pears, at certain times you might find yourself with fewer apples (or pears) than when and? entered (because everyone wants them and so many have been taken from the basket). This is the impermanet loss, or a momentary loss: it is sufficient that the next day there is a new demand for pears purchased by selling apples and everything is rebalanced.

Overall, providing liquidity to DEXs is probably the best way to increase your crypto hoard on a daily basis, but certainly not the easiest. For this reason it will remain a mode reserved for experts for a long time to come. At Anubi Digital, however, we have recently presented a new service, called DUO (yes, we didn’t have much imagination), which tries to make a rather complicated procedure simple, as we have seen. It will be interesting to observe if and how it will be received by the market.