Author: https://twitter.com/guiribabrb
Original Article: https://odysee.com/@ShapeShiftDAObr:a/provedores-de-liquidez:d

###### tags: `EN-TheSmith's-Collection`
# Liquidity Provider: Understanding How DeFi Protocols Attract Money And How You Can Help Them (And Earn From It)

One of the main challenges for developers is not only creating a secure dapp for users to use it, but attracting liquidity to the markets within it, that is, money. Since decentralized protocols don’t keep the direct custody of tokens, they depend on users interested in providing them liquidity. Liquidity providers are responsible for depositing money in the protocols to make possible the existence of the activities proposed by its creators. This supply of liquidity can come from in several ways, depending on the type of activity or even the strategy used by the platform to attract it.


In the article about *yield farming*, we explained about the possibilities of getting income as a reward for entrusting your tokens to DeFi protocols *smart contracts*. All activities listed in the text of the article described ways to get yield providing liquidity for different *dapps*.

In the case of decentralized brokers, such as Uniswap, any user can list a token to be traded on DEX. Thus, those interested in creating this market must insert liquidity in a 50/50 ratio: half in the token to be listed and half in the pair that will serve as the trading pair.

**This “package” of tokens is defined as a *pool*.**

According to the market’s interest in acquiring it, the token will be priced algorithmically according to the users’ supply and demand for it.


*For educational purposes: User A generates 100 tokens denominated FOX and wants to offer them to the market. In order to list it on Uniswap, it deposits, with the 100 Fox, 100 ETH. Thus, 1 FOX = 1 ETH. If someone deposits ETH to buy FOX, there will be less FOX and more ETH in the pool, making the amount of FOX smaller and making it more expensive for those interested in purchasing it.*
With the creation of a *pool for* trading the token, anyone will be able to provide liquidity for it. Usually, to execute this activity, the 50/50 ratio initially established must be maintained to help keep the token ratio in the pool balanced.

*Balancing the amount of 2 tokens in a pool is important to maintain the liquidity of both. If one of them has little liquidity for trading, its acquisition will end becoming more expensive, due to the so-called **slippage¹**.*

After the deposit, a certificate, **called LP or Liquidity Provider**, will be given to the liquidity provider user. This “bond” will represent your deposit in the *pool* and will allow you to withdraw liquidity and convert the LP back to your tokens and collect the rewards given by the *pool* creator and/or the protocol.

The rewards given to the liquidity providers are diverse: see annualized in native DEX token; tokens from partner protocols and even LPs from other protocols, using ecosystems developed by *dapps* such as *[Convex](https://www.convexfinance.com/), [Yearn Finance](https://yearn.finance/) or [Curve](https://curve.fi/).*

However, becoming a liquidity provider does not come without risks. When a user injects liquidity in a *pool* and receives his LP, this is automatically **subject to the risk of *Impermanent Loss*.**

Impermanent Loss is an inherent risk to any user who provides liquidity in a DeFi protocol. This occurs when the user deposits a certain amount of an X token and the equivalent amount in Y tokens and one of the two undergoes a great appreciation or devaluation. Changing the value of tokens after the LP is deposited in the *pool* can cause negative consequences, whether it is a loss in the token’s valuation or an excessive devaluation of one of the token’s pairs.

*So, if a user injects liquidity in a FOX/ETH pool and the FOX price increases and the ETH price falls, he will be failing to take advantage of the token’s appreciation, that is, he would obtain more profits just by holding it in his wallet.*

*.*

To understand whether you suffered an Impermanent Loss or not while providing liquidity, [you can use tools that optimize this calculation](https://dailydefi.org/tools/impermanent-loss-calculator/). However, it’s always good to be aware of how the DEX LP you have provided liquidity works. As an example, you can see [Uniswap V2’s](https://docs.uniswap.org/protocol/V2/concepts/protocol-overview/glossary) use of the constant product formula, but other formulas have been incorporated to allow users to provide liquidity in a concentrated manner in [its upgrade deployed in May, V3](https://docs.uniswap.org/protocol/introduction)

It is crucial to emphasize that Impermanent Loss holds this name because *it only becomes permanent when the user undoes his LP from the pool*, that is, withdraws the inserted liquidity and converts it to its original tokens. Even being subject to this risk, the ideal is to check the scenarios, prices and analyze whether these will return to their original value, avoiding only undoing the LPs for fear of suffering an Impermanent Loss.

Besides that, the rewards paid to liquidity providers can often outweigh the risk, depending on their profitability. However, the risk x return assessment must be based on user studies. Therefore, always do your own research and make sure you are ready to expose yourself to the risk of providing liquidity to DeFi protocols.

The safest way to provide liquidity to DEXes and expose yourself with less risk to Impermanent Loss is to deposit in token *pools* of stable values between them. One example is Curve, a DEX focused on stablecoins and which, in June, started having *pools* with assets such as BTC, ETH and their tokenized versions of other protocols such as Ren.

**The absence of variation between the *pool* tokens prevents it from Impermanent Loss**, being only exposed to the volatility of the value of its rewards for providing liquidity.

The innovation in the DeFi sector ended up bringing different ways to provide liquidity to *pools*. We won't go into detail at all, but we recommend reading documentation from Curve, Balancer, Yearn and Convex. Each one created different ways to attract cash into their *pools*, either by facilitating the user experience or increasing profitability for liquidity providers.

So study, evaluate the rewards options of the pairs to provide liquidity and see if these are compatible with the risks you are willing to take.

[ShapeShift DAO](https://shapeshift.com/) has a [FOX-ETH *pool* in Uniswap V2](https://fox.shapeshift.com/fox-farming/liquidity/0x470e8de2ebaef52014a47cb5e6af86884947f08c/staking/0xc54B9F82C1c54E9D4d274d633c7523f2299c42A0/lp-add) with incentives provided by ShapeShift DAO itself, with ~100% APY rewards in FOX, its governance token. Check out!

¹*slippage* is the term given to situations where the user, when buying tokens on a DEX, ends up acquiring a smaller number than he could buy. It can occur when there is a high volume of asset trades or, as mentioned in the article, there was low liquidity of the token for acquisition.