The world of decentralized finance (DeFi) continues to expand, allowing digital currency investors and asset owners to build their wealth or protect their finances against inflation. One of the latest offerings in DeFi is the automated market maker (AMM), also known in the crypto market as decentralized exchange (DEX) platforms. This has specific brands under different blockchains, such as Ethereum and BNB.
DEX platforms open investment opportunities to seasoned crypto traders and beginners by allowing them to become liquidity providers. Additionally, investors can earn money by converting their cryptocurrency into liquidity provider tokens and staking them in different pools where trading occurs.
Whether you’re a crypto world newbie or an experienced trader, you’ll need to be sufficiently informed about the nature of DEX trading and how to invest in liquidity provider tokens. Here are a few things to know about them.
Defining Liquidity Provider Tokens
Prior to the formulation of decentralized exchange platforms, trading cryptocurrency wasn’t as simple, and it had a particular impact on the liquidity of digital currencies. Liquidity is central to the growth and sustainability of the DeFi industry as it simplifies exchanges and transfers of assets, which is a critical aspect of trading. Moreover, liquidity allows investors to optimize resources by widening their investment options and making quick decisions regarding moving their funds. Hence, the rise of the DEX platforms paved the way to improved liquidity in the crypto world.
Liquidity provider (LP) tokens are certifications of share ownership provided to crypto investors who’ll lend their cryptocurrency to a pool where other users can easily exchange currency. These tokens can also be considered the primary currency used to trade on decentralized exchanges that utilize AMM. Similarly, LP tokens can be staked on their own or by pairs in various liquidity pools, which can be changed with other cryptocurrencies for a fee.
The transaction fees are then compensated to the investor to repay them for lending their currency to the pool. By adding to liquidity, it’s easier for those who want to exchange money to take the crypto that they need without having to go through intermediaries or traditional routes such as banks and the like.
How To Utilize Liquidity Provider Tokens
Your liquidity provider tokens prove that you invested funds in a liquidity pool. These tokens will then be your certification if you want to sell or redeem assets after earnings. Apart from these, you can also stake your LP tokens to earn more rewards.
There are two main processes that you can choose from when utilizing your LP tokens. Suppose you’re trading on a DEX platform under the Ethereum blockchain, for instance. In that case, your LP tokens or ERC20 can be sent to liquidity pools for investing, wherein you’ll select two cryptocurrencies in your wallet and put them towards the platform’s liquidity.
Besides staking, you can also invest in yield farming, where your initial investment will grow with interest. The funds are ideally locked in for a certain period to boost liquidity in the platform, and withdrawing them too early may cost the owner added transaction fees. However, the investment duration is also not considered a guarantee of great returns since they’re still subject to market demand and other aspects.
How To Earn Money As A Liquidity Provider
If you’d like a side income or want to invest in a trade that protects your assets from inflation, then DEX platforms might be your best bet. You have several options of DEX platforms, each one offering unique advantages. For instance, you can divert some of your Ethereum currency towards Sushiswap to take advantage of its competitive rates. Here’s how:
First, you need to open a crypto wallet and prepare the currency you’ll invest with. Then, connect the crypto wallet to the Sushiswap platform. Once done, you can explore the different blockchain networks for your token exchange and select one to swap your currency with. After the swap, store the tokens in your crypto wallet and choose the ones you want to add to the liquidity pool. For this purpose, you’ll need to invest two different types of tokens of the same number and wait for the right time to harvest your rewards. Most savvy investors choose to re-invest the reward tokens by staking them at the Sushibar, where they can double their earnings.
This purchasing, staking, and harvesting process can be observed in other DEX platforms, though each stage might be named differently. One thing to remember is to compare the transaction fees and earn potential across different platforms. As you start, it may also be helpful to research and gather enough information about investing in your chosen exchange platform until you’re confident enough to use your resources and make an investment.
Associated Risks In Investments
As with any other investment, transforming your cryptocurrency into liquidity provider tokens comes with risks. One of the well-known risks associated with liquidity tokens is impermanent loss. This type of loss refers to the decrease in cryptocurrency value while invested in a pool. When this occurs, it’s risky for the investor to hold a significant amount of the cryptocurrency since there’s no way to tell whether the price will improve.
While it’s possible to recover from temporary losses, smaller cryptocurrencies have a greater risk of collapsing than more established ones. On the other hand, it’s also possible for smart contracts to be breached or hacked, putting investments in liquidity pools at risk. However, these incidents are becoming less common, especially among the bigger and more established blockchains.
Investing in a DEX platform is an excellent start for those looking for opportunities in the world of digital assets. Purchasing and trading liquidity provider tokens allow quick, convenient crypto transactions that are mainly straightforward to learn, making them beginner-friendly.
Moreover, the earning potential is promising, given that the decentralized system attracts all kinds of crypto traders. As a DEX brand becomes popular, the growth potential also expands, thus increasing the investor’s chances of multiplying their initial capital. So, if you’re open to a new opportunity to grow your digital currency, the best time to invest in liquidity provider tokens is now.