You know that friend of yours who bought some odd-looking computers and started mining Bitcoin ages ago? Back then you thought it was stupid, now, not so much…
Imagine if you could go back in time and do what your friend did, and make a killing as a result of it! Well, now you can, and you don’t even have to buy expensive equipment that makes your electricity bill explode.
What you need instead is liquidity – crypto – in your wallet, ready to lock into liquidity pools that let DEXs – decentralised exchanges – function without any middlemen.
But before we get to the golden pot at the end of the rainbow, let’s back up a bit and get some context first.
What is a DEX – Decentralised Exchange?
A DEX is – as the name suggests – an exchange that allows buyers and sellers to trade assets between each other without a central authority in the middle maintaining an order book of buy and sell orders.
With blockchain and Ethereum’s smart contract functionality, DeFi – decentralised finance – was born. A wealth of dApps – decentralised applications – started popping up everywhere, and one of the killer apps were DEXs – Uniswap in particular – which gained incredible traction in no time. Just look at the TVL – Total Value Locked – from 1st of July 2020 to 1st of July 2021, starting at $1.8bn to its peak on 12-May-2021 at $88bn. That’s almost 50x in less than one year!
So how do these DEXs work? Taking the example of the most popular DEX to date – Uniswap – there are basically two main features:
- Swap
- Pool
Swap
This is the exchange functionality allowing traders to swap between various digital assets. The user interface is straight forward, all you have to do is connect your wallet and you are plugged in to play:
Pool
If you have cryptocurrency and are not looking to trade but rather stake your cryptocurrency and earn swap fees, then you can pool your liquidity into a liquidity pool, becoming a liquidity provider:
When you provide liquidity like in above example, you will receive ETH-USDC LP tokens, which are specific liquidity pool tokens for that specific pool.
What is a Liquidity Pool?
A liquidity pool is the underlying driver being DEXs. Without liquidity pools, DEXs wouldn’t function because there wouldn’t be any liquidity to trade with.
This is how DEXs show their true decentralized colors. Since traders pay a fee to trade one asset into another, someone is earning on those swap fees. For “normal” (centralized) exchanges like eToro, Coinbase, or Binance, the company behind these exchanges earn the swap fees charged when people trade. On DEXs like Uniswap however, the swap fees go to the liquidity provider.
In other words, simply by providing liquidity to a liquidity pool – and hence holding LP tokens – you as a liquidity provider earn fees from that pool.
These fees earned can be amplified when deposited to a yield farm
What is a Yield Farming Pool?
You have your liquidity. You have staked it on a DEX in a liquidity pool, so now you are holding some amount of LP tokens.
What do you do with this LP token? Well, smart people have managed to optimize the fees earned from these LP tokens by allowing you to deposit you LP tokens in a farm to further boost your passive income. There are countless yield farms, but I will use the example of Beefy Finance, which have launched their yield farm on multiple protocols including Ethereum, Polygon and Binance Smart Chain (BSC).
In the example below I am using BSC to connect my wallet, and as you can see the ETH-USDC pool yields 33.19% annually if I stake my ETH-USDC LP tokens on Beefy:
