One of the most common ways to earn yield in DeFi is by providing liquidity in decentralized exchanges. While for new investors this may seem initially as a straightforward process to earn returns, providing liquidity successfully has more intricacies that one should be aware of. There are certain indicators that can help to make more informed decisions about which pools are the most convenient to provide liquidity.
First, it is key to understand where yields are coming from. Trading fees are paid by traders that use these liquidity pools as a service to transact between the underlying two coins. Most pools have yields that are sourced exclusively from these fees. But the source of yield can also come from liquidity mining programs, where certain tokens are issued as a reward to those that provide liquidity in certain pools. These tokens are issued by protocols that have an interest in a pool maintaining a fair amount of liquidity to accommodate trades and damp volatility on the price of the token. This way they periodically pay liquidity providers a fixed amount of coins for providing liquidity. These incentivized pools are usually labeled as ‘farms’.
In this screenshot, it can be seen that this TOKE/WETH pool is incentivized by Sushiswap and Tokemak protocol by rewarding a certain amount of tokens periodically. The total annual percentage return (90.69%) is composed mostly from liquidity mining rewards (87.99%), since the fees generated by traded volume between these two coins would accrue for a return of just 2.70%.
Monitoring liquidity provided
The total amount of liquidity available in a pool is a sum of the total value of each of the two tokens locked in a pool. An increase over time of the liquidity in a pool is a sign that the pool is rewarding distinctively and capital is flowing into it. Liquidity always follows yields. Thus, a sustained decrease of liquidity over time could signal that the yields offered in that pool are not so incentivizing anymore.
Furthermore, it could signal that traders suddenly have a bearish perspective of the price action of the underlying coin and fear a price drop that could result in them holding the majority of the underperforming coin (this is impermanent loss, but more about this will be covered later).
But there is a trade-off. An increase of liquidity means that the exchange fees (and coin rewards in the case of a farm) accrued by the pool have to be distributed among more investors that provided liquidity. This means that the expected return might decrease for each of the liquidity providers. Overall, liquidity that is not consistently decreasing tends to be a good indicator of the health of the pool.
Review the yield provided
As seen on the Sushiswap farm example, non-incentivized pools that just rely on fees as rewards tend to return low yields. But that is not…
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