Learn all about how DeFi users take advantage of high APYs to “farm” yield via liquidity pools.
Why is liquidity important? What does providing liquidity involve and where do the rewards come from? And what are some of the risks involved?
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DeFi offers the potential to make much higher returns on your assets than traditional finance. Many projects will incentivise users with generous rewards to maintain a liquid market for their token via liquidity pools.
Liquidity is important for any asset; something is only worth as much as you’re able to sell it for. Automated market makers (AMMs) use pools of paired assets to provide a liquid market for users to trade.
AMMs need users to deposit their funds into liquidity pools and the locked funds are represented by tokens which act as receipts. These LP tokens keep track of the underlying assets and the fees earned, and can also be staked to gain further rewards.
Yield farmers tend to hunt the highest Annual Percentage Yield (APY) in order to maximise returns on their capital. DeFi can be a very lucrative place to invest, but sky-high APYs are often too good to be true. Especially when it comes to long-term investments.
Providing liquidity earns trading fees for yield farmers as well as potential staking rewards. However, the automated nature of liquidity pools on AMMs can lead to losses when compared to simply holding the tokens. Are the rewards worth the risk of impermanent loss?
The innovative offerings of DeFi tempt many users into chasing high yields around the blockchain space. As we have seen, liquidity is essential for any asset, and many projects are willing to pay handsomely to keep their assets on AMMs. However, high APYs can’t last forever, and when dealing with more volatile assets, the risks may outweigh the returns.