DEXs, Liquidity & How LP Farms Work

DeFi, or decentralized finance, has been a growing niche and blanket term in the world of cryptocurrencies since 2019. Some prominent functionalities under DeFi include lending protocols, payment applications, and Decentralized Exchanges (DEXs).

Yield farming in the form of staking and LP farms are a few of TokensFarm’s central aspects. This blog post will discuss the DeFi functionality of providing liquidity to DEXs and Liquidity Pool (LP) farming.

The History of DEXs & Liquidity

In 2014, following the announcement of Ethereum, Vitalik Buterin and others discussed how to utilize Ethereum to the fullest. One of the ideas that grew popular was the concept of DEXs. DEXs are direct peer-to-peer cryptocurrency exchanges that operate without an intermediary.

Roughly a month after the concept of DEXs started circulating, the leading Bitcoin exchange Mt. Gox experienced a devastating hack. Mt Gox lost 850,000 Bitcoins belonging to its users and was forced into bankruptcy. Mt Gox’s hack highlighted the security risks associated with centralized exchanges.

One of the first DEXs to operate was EtherEX which became inspirational to the next generation of DEXs. Some of the issues with EtherEx was that every trade required a fee and confirmation from the Ethereum network. Fees and confirmations made trading on EtherEx costly and slow. Some also criticized EtherEx’s order book UI.

The next generation of DEXs started with EtherDelta. The main difference between EtherEx and EtherDelta is how the order book operates. On EtherDelta, the order book was off-chain as opposed to EtherEx’s on-chain order book. Taking the order book off-chain sped up transactions and reduced fees while keeping the trade execution on-chain.

EtherDelta’s leading developer encountered legal trouble, and other DEXs took its place. Another DEX that revolutionized the trading process was Bancor which introduced the concept of automated market makers (AMMs).

AMMs, Modern DEXs & Liquidity

AMMs replaced order books with a sleeker UX that calculated the prices of tokens automatically. Price calculation is done with the use of user-provided liquidity pools. Each tradable pair requires nearly equal pools of the two assets. In exchange for liquidity, users receive LP tokens representing their share of the pool.

Liquidity pools receive an average allocation of 0.25 percent in trading fees in that pool from the DEX. Increasing the size of the pool incentivizes the liquidity providers. Providers of liquidity can remove their liquidity from the DEX and get their proportion of token pairings back by returning the LP tokens to the DEX.

Today, nearly all DEXs have followed Bancor’s path and now work with automated market makers.    

LP (Liquidity Pool) Farms & Impermanent Loss

Providing liquidity is usually a profitable venture for most DeFi enthusiasts, although simply holding tokens can sometimes be more beneficial. These situations are called “impermanent loss.” Impermanent loss may be slightly misnamed, as the liquidity provider can still be profitable during these times of volatility.  However, the liquidity provider would hypothetically profit more by holding tokens.

A clever way for liquidity providers to mitigate impermanent loss is to seek out pairs with LP (Liquidity Pool) farms. Crypto projects deploy LP farms to reward liquidity providers for providing liquidity for a particular token pair on a specific DEX. The liquidity provider will need to deposit the LP token they received from the DEX on the farm’s smart contract. In exchange, the liquidity provider gets token rewards from the project.

The token rewards can help minimize the threat of impermanent loss for liquidity providers. Crypto projects also benefit from the deployment of LP farms as they ensure consistent & deeper liquidity on a DEX. Because there are more market participants and orders in a liquid market, prices are stable enough to absorb large orders. Pricing and charting formation are more developed and accurate in a liquid market, enabling more accurate technical analysis. Liquid markets also tend to be more popular with traders.

TokensFarm’s Customizable LP Farm Features

At TokensFarm, crypto projects can deploy LP farms without coding or integrations. The LP farm’s images and colors are completely customizable and are up to the crypto project. The duration and the number of token rewards are also customizable to fit the project’s goals.

Typically it is recommended to reward stakers generously and set a duration of at least a few months for an LP farm. By doing so, the farm can maximize its effect and draw in DeFi enthusiasts unfamiliar with their project.

Projects can also set unique warm-up & cool-down periods on farms. Warm-up periods mean farmers will need to wait a predetermined amount of time while staking before receiving rewards. Cool-down is a very similar concept. With cool-down periods farmers are required to wait a specific amount of time before withdrawing a portion of their stake or its entirety.

With a flurry of settings, easy deployment, and excellent results for farmers and projects, it’s easy to see why TokensFarm’s LP farms are popular!