The other week, I introduced DEXes and demonstrated how to use a Cardano DEX. Using a DEX to exchange tokens is almost everyone’s first step into DeFi, but many may want to actively participate in the DeFi economy.
The most common next step is to become a Liquidity Provider (LP) and supply liquidity to a DEX. This has many benefits for the individual and other users but also comes with risks.
What is a Liquidity Provider?
The “become-the-bank” ethos of the Web3 movement means that DeFi protocols, unlike conventional banks, do not have large holdings of other users’ assets to conduct financial activities with.
Instead, users, known as liquidity providers, supply funds to DeFi protocols to facilitate financial activities, e.g., token exchanges.
Why is Liquidity Important for DEXes?
Most DEXes use an Automated Market Maker model, explained in my previous article, where users buy tokens from pools of token pairs, called liquidity pools. Having liquidity in these pools is essential. No liquidity means no possibility of exchange.
Having more tokens, i.e., deeper liquidity, in these pools means that users will experience less slippage, resulting in a positive user experience as token price doesn’t change massively when they exchange large quantities of tokens.
What You Get for Being a Liquidity Provider on a DEX
Users who exchange assets on a DEX pay a small liquidity provider fee. This is proportionally split between the pool’s liquidity providers and is withdrawn with their deposited liquidity.
DEXes also offer liquidity provider incentives—helping them to achieve deeper liquidity—through Farms. When depositing liquidity to a DEX, you receive LP Tokens representing your deposit, allowing you to retrieve it.
Some LP tokens can be staked in a Farm, and doing so will provide the LPs with extra rewards, typically distributed in the platform’s native token.
What Are the Risks of Adding Liquidity to a DEX?
Partaking in DeFi does involve risks, the most prominent being hacks and poor code. So, it is essential to do your research and to look for a secure DEX. What helps make a DEX secure? Learn all about DApp security here!
The other risk for LPs is impermanent loss. The ratio of tokens in a pool fluctuates due to price changes, and if the token ratio is different when an LP withdraws their tokens from the pool then they make this loss permanent (this loss can also be a gain)—learn more about impermanent loss here.
How to Add Liquidity to a DEX
As before, I’m going to use Minswap. However, the process is similar across all DEXes.
- Select “Connect Wallet” from the menu bar of the Minswap app and connect your wallet.
- Select “Liquidity” and then “Pool” from the menu bar.
- This gives a searchable list of the liquidity pools to which you can add tokens. Click on a pool to see the stats of that pool, and click “Add Liquidity”.
- Now, enter the quantity of tokens you want to add. Add in the amount of one token, and the platform pre-fills an equal value of the other. We’ll add all our MIN. Now click “Add Liquidity” and sign the transaction.
- Once your transaction is successful, click “Liquidity” in the menu bar and then “Your Liquid”.
- Here, you can view, remove, and add to your liquidity. You can also see your existing farms. To add LP tokens to the farm, click “Farm” in the menu bar and then “Farm” again.
- Here, we see the APR for all the pools eligible for additional rewards through the DEX’s Farm. Find the pool you supplied liquidity to and click stake.
- Select the number of LP tokens you want to stake to the farm with the slider or buttons, and then click “Stake” and sign the transaction.
- Once your transaction is complete, you can return to the Farm page to check and harvest your rewards and withdraw your LP tokens from the farm, which you can then use to remove your liquidity from the DEX.
Congratulations! You just contributed to the DeFi economy
and maximized your returns!🎉🎉
Cardano DeFi has Only Just Started!
Becoming an early contributor to the burgeoning Cardano’s DeFi ecosystem has many benefits, but participating in DeFi at the moment does come with risks, and doing your research to find the risk/reward balance that suits you is crucial to your peace of mind and your continued contribution to Cardano DeFi!
Disclaimer: This article is not financial or investment advice, it is solely an excellent how-to guide for using a decentralized protocol. Using decentralized protocols comes with inherent risks which the user assumes the whole responsibility for.