Decentralized exchange's (DEX's) allow for the swapping of tokens without the necessary counterparty (i.e. buyers and sellers) that you would expect in an order book model seen in traditional finance. Rather, DEX's allow users to buy or sell a particular asset by interacting with a liquidity pool through an automated market maker (AMM). In its basic form, liquidity pools hold two token assets in equal measure and these pools of tokens sit inside of smart contracts that are used to facilitate trading. Instead of an order book system where the price of each asset is determined by the highest buyer and lowest seller, the automated market maker (AMM) system completes trades for users on demand. It works by increasing and decreasing the price of one asset depending on the ratio of how many tokens there are proportional to the other token in the liquidity pool.This may seem quite complex at first but we will go through everything thoroughly to gain a better understanding:
Liquidity Pools became hugely popularized through projects like Uniswap (one of the first decentralized exchanges). Essentially, these liquidity pools hold two or more tokens of equal value (eg. $1000 of SOLID: $1000 of FTM) and these pools are used to facilitate trading. Since the price of the tokens is determined by the ratio of the two tokens, the more liquidity that sits inside the pool, the easier it is to trade in and out of the pool without causing massive price fluctuations, and this is called price slippage.Users can put up their liquidity (by providing both assets) so that there is sufficient liquidity to trade on. But how do we ensure that there is enough liquidity in these pools?In order to incentivize users to put up their liquidity, protocols charge a small percentage (%) on trades that is then used to pay out to the users who provided liquidity (LP's).
Users can provide their liquidity into these pools and earn trading fees as yield. The more volume that is traded, and the more liquidity you provide, the higher your proportion of rewards will be.However, to incentivize this even further, protocols started to payout LP's in the the protocols native token to amplify this yield. Now liquidity providers can earn trading fees as well as inflationary token rewards.Curve.fi is an example of this where users can provide liquidity and earn trading fees as well as inflationary CRV rewards.
Certain protocols allow for the single sided staking and locking of assets. These 'stakers' can earn rewards in many forms, but the most common is in their native token, or in protocol fees. Some protocols also incentivize the locking of Assets to receive veAssets (eg. vote escrowed assets). Not only does this reduce the amount of tokens in circulation, but it also allows users to vote on proposals, earn boosted rewards and in some instances, qualify you for potential airdrops.
Staking is the process through which a blockchain network user 'stakes' or locks their cryptocurrency assets on a network as part of the consensus mechanism, thus ensuring the security and functionality of the chain. Staked assets are usually held in a validator node or crypto wallet, and in order to encourage staking most projects reward the holders of staked tokens with annualized financial returns, which are typically paid out on a regular basis. Staking is a core feature of Proof-of-Stake (PoS) blockchain protocols, and each blockchain project which incorporates a staking feature has its own policies for staking requirements and withdrawal restrictions.
One of the biggest risks when providing liquidity is known as impermanent loss (IL). IL happens when you provide liquidity to a liquidity pool, and the price of your deposited assets decreases compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit. This often occurs when the price of one asset (or both assets) decrease while you are providing liquidity. However, certain pools that contain assets of equal value (such as stablecoins and wrapped versions of a coin) will stay in a relatively contained price range. In this case, there’s a smaller risk of impermanent loss for liquidity providers (LPs).There are also additional risks in the form of smart contract bugs. Considering how new the cryptocurrency industry is, there are inherent risks when interacting with any decentralized-finance smart contracts. Many projects get audited beforehand to ensure as much security as possible. However, please ensure to exercise caution, as always, the possibility of losing some or all your funds is not impossible. Therefore users should always invest within their personal risk threshold.