understand what it is and how to use it

In decentralized finance (DeFi)it is common to come across at least two terms: farm and liquidity pool. The latter can also be translated as a liquidity pool. Both are very important in the functioning of DeFias they ensure good operation of the market and allow investors to receive income about your tokens.

But what is a farm and how does it work? And the liquidity poolswhat they represent to the DeFi tokens? In a way, they use smart contracts to provide services similar to the traditional market, but with the characteristics, advantages (and risks) of DeFi. Today we will check out what they are and how they work.

Liquidity pools

You liquidity pools are fundamental tools to ensure the proper functioning of the market. They work by allowing users to leave their tokens blocked in exchange for rewards. Locked tokens ensure that the market will have a offer sufficient and, with that, the negotiations may occur without problems liquidity.

It is important not to confuse liquidity pools with mining pools via Proof of Work (PoW) and Proof of Participation (PoS). Despite the similar names, the function of each of them is different. Liquidity pools ensure and increase the liquidity of negotiations, especially between the decentralized exchanges (DEX).

The more pools a DEX has, more easy is to negotiate the tokens that are listed in it. Each pool is linked to a smart contractin which users deposit tokens to the DEX. These depositories are called liquidity providers or liquidity pool (LP, in the English acronym). The process works as follows;

• The PL choose which pool I would like to negotiate;
• He send the tokens for the address from the pool’s smart contract;
• Having done this, he receives the pool tokens that prove your investment;
• THE remuneration occurs through the rates paid on each transaction.

How a liquidity pool works

Generally speaking, a liquidity pool is made up of a token pair. For example, the pair DAI and Ether (DAI/ETH) is a pool formed by the stablecoin DAI and the cryptocurrency Ether. Each pool offers a new market for the tokens that form the pair. A user who wishes to provide liquidity to this pool needs to deposit an equal amount of both tokens.

That is, to offer liquidity, someone who deposits R$100 in ETH will need to deposit R$ 100 in DAI. Deposits are made through the address that makes up the smart contract. In this scenario, the LP contributed a total R$ 200 in the pool, having a share proportional to the amount deposited.

He may withdraw the total in ETH or DAI at any given time, with total liquidity. An LP provides liquidity primarily to DEX. The Uniswap is one of the exchanges that have greater liquidity in the market, precisely because of the large number of LPs on its platform.

This model has a difference in relation to the traditional exchangessince it does not depend on orders. Thus, the LP only needs ask withdrawing your funds to receive them immediately. Liquidity pools eliminate the need to issue buy or sell orders and having to wait for a seller or buyer to execute them.

Incentives for providing liquidity and withdrawing funds

In addition to the ease, LPs receive incentives to keep your tokens locked in the pool. Each deposit made generates a token for them, called pool token. In the DAI/ETH pool example, the generated token would be called DAIETH. This token entitles you to benefits as participation in the fees generated by the DEX on each trade.

For example, let’s imagine that the trading fees for the DAI/ETH pool to be 0.3%. An LP has made contributions (also called bets) with an amount that equals 10% from the liquidity total pool. This LP will be entitled to 10% of 0.3% of the total value of all negotiations. The first LPthe one who provides liquidity to the pool, will also be able to set the initial price for trades.

If you wish to remove the funds invested in the platform, the LP must carry out the burn of your pool tokens. With this process, the tokens are discarded from the market. After that, he can withdraw the amount locked in the smart contract. The process is, as seen in the previous topic, fast and without the need to place orders on the exchange.

The importance of liquidity

Liquidity pools are important to ensure the fluidity of DeFi token trading. As it is a very new market, DeFi is not known of most people, which makes necessary this liquidity, allowing there to be no problems in negotiation of tokens. Thus, liquidity helps prevent a series of problems:

• Risks of attacks hackers;
• Difficulty in buying or selling the tokens;
• Manipulations priced by large investors;
• Rescue of money by liquidity providers.

Markets with low liquidity are more subject to attacks, both in price as in the networks itself. These attacks can cause a huge prejudice financial to token holders. Without liquidity, a large investor can to bring together a few thousand reais or dollars and manipulate easily the price of a token.

Let’s take the market as an example Bitcoin (BTC). It moves billions of dollars every day and has trades in practically all the world’s exchanges. This makes a collapse total in its price is practically impossible to occur. It is also one of the factors that makes BTC tradeable virtually anywhere.

Yield Farming

One of the goals of DeFi is to bring traditional financial services to the cryptocurrency market. And one of the tools that makes this possible is the yield farming. In short, it is a way that the investor can use to earn more DeFi tokens without needing to mine or trade.

Yield farming works in a similar way to investments that yield fees. In this way, he is able to produce a passive income for token holders. Although this explanation may seem simple, the process involves relatively complex operations. complex. And to avoid confusion, we will bring a summary detailed, yet accessible, of these operations.

How it works

In some ways, the process of yield farming has similarities to mining via Proof of Stake (PoS). For example, DeFi token holders leave their tokens blocked on a platform. With this they receive income in exchange for the immobility of these tokens. Many yield farms offer yields in the range of two digits per year, higher than most traditional fixed income investments.

Despite the similarities, yield farming is quite different. It does not include the “miner”, as the tokens are not mined. The LPs are also part of yield farming, giving liquidity to the pool. In return, they are remunerated with rewards or payment of fees. Here are some examples of protocols that allow this:

• AAVE;
• dYdY;
• PancakeSwap;
• Uniswap;
• Compound.

Calculation of returns

You fees payments in this modality are generally calculated in terms annual. Thus, yield farming that pays 10% means that the investor will have a 10% return after one year of investment. There are two main metrics used in calculating annual returns:

• Annual Percentage Rate (APR, in the English acronym);
• Annual Percentage Yield (APY, in the English acronym;

Despite the similar names, there is a very important difference between the two. A pool that uses the APY takes into account the effect of compound interest in income. A pool that uses APR operates based on simple interest. And the choice between the two can have a strong impact in the income obtained.

In the case of simple interesta percentage is charged on the value of the main. Just as an example, imagine a yield farm with an APR of 10% per year. An investor invests 10 COMP in it, which would give an annual yield of 10%. Thus, he would have 11 COMP in the first year, 12 in the second, etc. The calculation is based only on the principal amount.

Already in the model of APYthe calculation of interest takes into account not only the amount invested, but also the sum of the interest that has already been paid. In the same example, the investor who starts with 10 COMP would have 11 COMP in the first year, 12.1 in the second, 13.3 in the third, and so on. This is because the interest is charged on the entire accumulated valuewhich brings returns exponential in relation to the APR.

One of the best-known protocols in this market is yearn.finance (YFI). Released in 2020, it is a aggregator that allows investors to carry out operations automated in DeFi. Its goal is to maximize investment profitssomething that has actually been happening. In the last 12 months, the YFI token had a strong appreciation, becoming more expensive than BTC.

Advantages and risks of yield farming

Yield farming operations have the great advantage of making the tokens work for the investor. Through DeFi, it is not necessary to leave them stopped in a wallet waiting for the appreciation. With the interest paid, it is possible to generate a passive income constant and, in many cases, above of interest paid in the markets traditional.

However, the operations of this sector no are simple. Many strategies require advanced knowledge to be executed. In addition, it is necessary to pay attention to the risks of the protocol. Any errorwhether by design or committed by the user himself, can lead to a loss total money invested.

Another point is that the returns no they are stablebut they vary according to the market. Again, the liquidity has a great influence on this process. The yield farmers – name given to users who participate in the process – have a high degree of mobility. They are always looking for projects that offer the better income. But you also need to check which ones offer the highest degree of security for an investment of long term.

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