The concept of liquidity describes how easily an asset can be sold or bought. If you purchase something that makes a considerable profit, but you can’t sell it, then it’s illiquid, and you can’t realize your gains. Not a great position to be in. Luckily in traditional financial markets, exchanges, and other trading venues employ market makers. These market makers make it easier for traders to buy and sell by quoting prices to buy and sell an asset.
When you think of orderbooks of exchanges with buy orders on the left and sell orders on the right, market makers put orders at different price points and sizes into the books. They then benefit from arbitrage while ensuring that little traders like me can exit positions fast.
What works for traditional exchanges and brokers is also done on centralized cryptocurrency exchanges. They work with market makers to ensure that whenever a token is going live, traders won’t have to sit on their unfilled orders forever — it might still sometimes happen. Either because the price you want to sell for is so high that no one accepts it or simply because there is zero demand for whatever you’re selling. The market can be a b*tch.
What works for centralized exchanges can’t be replicated easily in decentralized exchanges (DEX). While they are called exchanges and facilitate exchange, you’re not interacting with other traders. Your orders aren’t matched with another person selling what you want. What happens in the backend is that you put money into a smart contract.
Smart contracts are called smart, but they aren’t smart enough to know what prices assets are trading for outside of the smart contract environment. They’re just computer code, after all. No offense 🤖
When sending your tokens to a DEX, it will send them on to the smart contract that provides liquidity: the liquidity pool. The liquidity pool is full of different tokens that traders can swap, acting as a market maker. Since the smart contracts don’t know what prices assets are trading outside of their little world, a mathematical formula instead defines the prices. For Uniswap, for example, that formula is:
x*y=k — where the X and Y represent the amount of each token in the pool, and K is a predefined constant
Without doing any higher math, you will mainly experience slippage whenever buying from a DEX, which means you’ll have to adjust your price tolerance level. I did that too last time when buying CATE on pancakeswap. Only once I accepted a 20% slippage was I able to buy. It’s not for the faint-hearted.
So far, we know what liquidity is and what market makers do in the regular financial system. I also covered that it doesn’t quite work like that on decentralized exchanges because they just run on code without information from the outside world.
Now the last open question is, where do the tokens in the liquidity pool come from? And this is what liquidity mining answers. 💡
Liquidity mining is also known as yield farming. Traders like you and I can deposit tokens into a liquidity pool. As a token (wordplay intended) of gratitude, we receive some interest on top and often the native currency of the platform. Interests on whatever we decided to put in are partly financed by transaction fees people pay who swap inside the pool.
Then, the question remains where does our token come from? It’s magic internet money. ✨It should be explanation enough.
For everyone who doesn’t buy the magic, it’s usually the exchange token or platform token. One of the first exchanges to introduce liquidity mining was IDEX back in 2017. However, the idea took off when Compound labs decided to award their liquidity providers (people who deposit into the liquidity pool) with the COMP token. Good for early providers, because COMP price went from less than $70 to $700 in May this year. Lucrative business this yield farming if you get lucky.
So I decided to try my luck too. Thanks to a Brave Ad, I stumbled across Cake Defi. I love cake, so why not. The ad also promised me that I could retire early. That’s my dream.
The website advertises different liquidity pools, with the USDT — DFI pool offering up to 96% APY. You earn back your money in a little over a year, kind of. There’s really just one reaction for me to such an offer.
Imagine if they’d take whatever money I had. Of course, Cake DeFi doesn’t. I don’t blame them, though. We’re in the world of crypto; after all so, they only want my crypto, and fair enough, that’s what I signed up for.
Of course, I have USDT on exchange. USDT-ERC 20 so, the USDT where you can quickly pay 10% of whatever you transfer in transaction fees. Putting USDT into Cake, easy.
But then I realized that to provide liquidity to the pool; I also had to put up the same amount of the other token. Just like a market maker on a stock exchange puts up $50k sell orders and $50k in buy orders on a specific asset. I should have thought about that earlier.
Next step, buying the DFI token. Is it listed on any of the exchanges I have an account on? That would’ve been too easy.
Checking the website, I found around 5 exchanges listing it. One of them is Bittrex, the others I’m less familiar with, so I decided to go for Bittrex. I should have checked if they require verification first because a few moments later, I was scrambling for my passport and trying to take a halfway decent selfie for KYC.
Verification passed ✔️
2-FA activated (because better safe than sorry) ✔️
Fund account ✔️ but what pains me is that I paid 10% of the amount I transferred in USDT in transaction fee, and if now you come along with “Bitcoin fixes this,” I don’t want to sell my BTC for anything at this point. Sign me up for team diamond hands.
So, in the next step, I bought some DFI on the exchange. Then I realized that I didn’t even know what token standard DFI was. At this point, I confess to not always doing all my own research.
It seemed to not be ERC-20 but built on Bitcoin, exciting. So at least my transaction fees to send DFI to CAKE weren’t as high.
Next step, depositing USDT on Cake. And what does it say “please note that we’ll require a $75 fee on the first USDT-ERC 20 deposit”. Hm, nah. I wasn’t willing to pay that but, also not ready to completely give up on liquidity mining.
So, the next possible pool was BCH -DFI offering more than 80% APR (how much you can earn). Fine, at least I knew that BCH deposits were cheap. So I went to my exchange, swapped USDT to BCH, and then deposited it to Cake. Pretty sure exchanges make a lot of money of me because I forget to check what is accepted on other platforms.
If I were to count how many confirmation e-mails and 2-FA codes I used throughout the process, I’d go crazy. 🤪