The short answer is yes, you can reliably make money from becoming a liquidity provider by earning a portion of the trading fees imposed by the DEX on traders. Bear in mind, however, that this all comes with its own caveats and risks you must understand.
We’ll briefly cover some of the risks of becoming a liquidity provider, before discussing how liquidity providers can earn revenue from DEX trading.
Risks for Liquidity Providers
1. Security
While the idea of providing idle digital assets to a DEX’s liquidity pool for additional income may be appealing, it is important to note that the biggest risk you will take as a liquidity provider is that you will be putting your funds outside of the security of your own wallet.
This doesn’t mean you’re transferring your custody of the funds; you still control the digital assets and can always take them back, but you would have to trust that the automated scripts or codes that manage your funds will work as they should.
These scripts, called smart contracts, are the only ones controlling the way trades work in the liquidity pool and have no central authority or custodian taking care of them. Should a smart contract have a bug or vulnerability that can be exploited, your funds could be lost and no one would be able to help you reclaim them.
This risk is usually referred to as the smart contract Another thing that liquidity providers should keep in mind is smart contract risks. Once assets have been added to a liquidity pool, they are controlled exclusively by a smart contract, with no central authority or custodian. So, if a bug or some kind of vulnerability occurs, the coins could be lost for good.
Generally, younger or newer platforms that haven’t had their smart contracts properly or robustly audited will be the ones more at risk of security attacks. That said, even Uniswap, one of the oldest and most secure DEXs, was hacked in July 2022, allowing thieves to steal some $3.5 million in Ether from its liquidity pools.
2. Governance
While this might be considered a non-critical risk, it is important to note that DEXs are not generally as decentralised in terms of governance as they might suggest.
In fact, most DEXs actually are very much under the control of their own developers, who are able to implement changes and manipulations on their own. Some older DEXs such as Uniswap, have tried to transfer some of the control over to their community, in particular by distributing their own UNI token to users. In theory, UNI gives users the rights to vote on decisions taken by Uniswap, including new ideas and features and even developmental direction.
In practice, however, most governance tokens of DEXs are still concentrated in the hands of a few wealthy individuals and, often, their own developers.
Should you be unfortunate enough to provide liquidity to a DEX controlled by developers who suddenly decide to go rogue with a hostile takeover of a liquidity pool’s assets, there wouldn’t be much you could do about it.
3. Impermanent loss
We finally arrive at the technical risk that liquidity providers are exposed to, which is impermanent loss.
To think of this in simple terms, consider that the dollar value of a liquidity providers assets could decline over time. For example, you could provide 1 ETH worth $1,500 and $1,500 worth of USDT into a pool. However, over the period of 24 hours, ETH price volatility is so high that it drops several times a day to $1,200 and even $1,000.
The loss happens if traders swapped out your ETH at these deep discounts. It is called impermanent because you don’t lose anything if the price returns to $1,500 – essentially, you don’t realise any profit or loss for as long as you keep your assets in the liquidity pool.
During this period of extreme volatility, you could see a big loss due to impermanent loss.
Since impermanent loss occurs due to trading pair volatility, most liquidity pools use at least one stablecoin in the pair (stablecoin values are pegged to fiat, so their value remains virtually unchanged). Perhaps the lowest risk of impermanent loss is when both assets in the liquidity pool pairs are stablecoins.
Liquidity Provider revenues
The attraction of liquidity pools is that it allows people to trade digital assets immediately and in an automated way, instead of the traditional way of CEXs where you are essentially putting up orders or taking other offers to sell and buy digital assets.
In other words, when you swap with a liquidity pool, your swap is automatically carried out, based on your settings. Prices are also determined automatically, with the DEX’s own mathematical formula that constantly adjusts based on the activity of trading as well as the general market value of the assets globally.
The other benefit is the lower cost associated with swapping or trading at liquidity pools on DEXs. While Liquidity Pools do charge a fee or commission for trading, it is typically a small percentage of the transaction value and often, not as high as that of a CEX.
This fee or commission is the main revenue generation for the liquidity providers since DEXs generally distribute most of the fees to liquidity providers as a reward for providing their assets to the liquidity pools.
Naturally, DEXs will try to entice more people to provide liquidity to their platform – the more liquidity you have, the easier it will be to attract traders with larger volumes since deeper liquidity also translates to lower slippage for traders (the difference in the price desired verses the actual price acquired).
As such, DEXs now offer more and more ways for Liquidity Providers to earn more income and diversify revenue other than through direct liquidity provision. This is usually achieved through further manipulation of LP tokens. How this happens and what LP tokens are is covered in the following section.
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