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Arnaud Deblander
Apr 26, 2022 12:06 PM

At the time of writing this, the crypto market is at a stage where optimism is lacking, with Bitcoin at half-mast and a bullish trend that is struggling to get going again; leading to fears of a further fall. Nevertheless, there is one sector where you can still make money: decentralized finance (DeFi)!

As part of our DeFi ecosystem content, we will explore ways to help you make money from crypto (even when the market is lackluster!). Last week we delved into liquidity pools. This week we will revisit the subject, with a special focus on liquidity tokens.

What are Liquidity Provider(LP) tokens?

What is an LP token? Well if you remember our previous article on liquidity pools, you know that it is a way to ensure liquidity on a decentralized exchange platform, such as Uniswap or Pancakeswap. Adding liquidity to a decentralized market is always done in pairs, ETH/USDC for example.

When we, the liquidity provider, receive our reward in the form of a liquidity “LP” token. Let’s take the case of Uniswap, if we decide to add liquidity to the Uniswap ETH/USDC pool, we will receive LP tokens in return, in this case, UNI tokens. These tokens track your contribution to the pool and are used for distributing your share of the transaction fees accumulated in the same time period that you provide liquidity for.

Characteristics of LP tokens

Although there is a multitude of LP tokens, they all share some common points:

  • Each LP token works on a blockchain and with a unique standard. This can be the ERC-20 standard for those who use the ETH blockchain or the BEP-20 standard for users of the BSC blockchain.

  • The value of the LP token depends on the total value, TVL or “Total Value Locked” of its platform of origin.

  • A burn that occurs for any reason will always positively affect the value of the token, this is the principle of supply and demand.

  • However, there are some specificities of each platform that issues LP tokens, which you should read before taking any liquidity position on a DEX exchange.

How does a CEX work?

A decentralized exchange platform works differently from a more traditional centralized exchange platform. The latter uses an order book model, which matches buyers and sellers. That said, if a buyer wants a lower price than the seller is willing to accept, there will be no exchange.

This would be the case if they did not have recourse to market makers whose aim is to ensure an immediate counterparty and therefore liquidity in the market. A centralized exchange platform usually uses several teams of market markers.

The market makers are paid by the centralized trading platforms to provide liquidity, but they also get paid on the bid-ask spread. Behind this term is simply the difference between the best available price and the best price

How is a DEX different then?

One of the main differences between a centralized exchange and a decentralized platform is anonymity. As you probably know, on a CEX such as Binance, your funds are held in hot wallets, directly at Binance and you, therefore, need an authentication system to use them.

Also, in order to use most centralized platforms, you have to pass a whole series of KYC, which removes any possibility of anonymity at once. For DEX, the situation is a bit different because you keep the sovereignty of your funds, they remain in your wallet.

We could use the order book model on a DEX exchange platform but it would be very slow and illiquid in the absence of a centralized third party (Market Maker).

Automated Market Making

The creators of decentralized platforms have therefore imagined a way to provide liquidity to the market through automated market-making algorithms. This is where liquidity providers come into play. By deciding to add liquidity to the ETH/USDC pool, for example, you become a market maker yourself. You allow traders who prefer to use a decentralized platform to have a counterparty at all times.

It works as follows: If you want to add liquidity to the ETH/USDC pool, you will need to bring in a portion in ETH and a portion in USDC. Why would you do this? In constant function market-making algorithms, like Uniswap V2, the price is a function of the quantity of Asset A and Asset B available. The % of ETH and USDC, initially 50/50, within this pool is bound to be modified to keep the price in line with its market price.

If the price of ETH rises, more and more liquidity providers will withdraw from the pool to resell them, which will decrease the ratio of ETH to USDC.

What is the risk?

As you can imagine, all is not so rosy, the ratio between ETH and USDC is always moving in the liquidity pool, just collecting the fees as a risk-free liquidity provider would be too easy right?

Of course, there is a risk called impermanent loss, which is the opportunity cost of using your capital in the pool rather than simply HOLDing an asset. It is of course more complicated than that but the idea is there.

Conclusion

You now know what an LP token is – you receive it when you decide to add liquidity to a pool. It may seem that LP tokens play a small role in the ecosystem of trading but nonetheless, it plays a huge role in ensuring liquidity in the DeFi space.

If you are wondering whether there are other ways of making money, you have come to the most exciting part of this article! SuperBots, a Web 3-focused project, is dedicated to making money fun! Through its three core pillars of Invest, Stake, and Gaming, you can make money in crypto effortlessly.

The Invest component consists of fully automated algorithmic trading bots that trade on DEX. Each vault is governed by an algorithm and takes place fully on the blockchain via smart contracts. The best part of this – it works on a performance fees model. This means, that if the vaults don’t make a profit, you do not pay for using them. And when there is a profit, the performance fees are distributed to the staking pool and developer of the algorithm.

With Staking the native token, UBXT, besides earning attractive rewards, you will also receive a percentage of the performance fees paid by users and investors. Alternatively, if you prefer to stake your USDT in the vaults, you will also receive UBXT in return – all done automatically by the vaults for you. Launching in the near future, more staking pools will be launched. This means, you will have the option to stake UBXT and in return, receive tokens from other projects present on Superbots!

Through the Play component, coming soon are a series of exciting games in the metaverse and NFT collectibles with utility tied to the Superbots ecosystem! Keep a lookout for the SuperBots NFT Whitelist! You wouldn’t want to miss it!