Introduction

What is Liquidity Providing? Liquidity providing is synonymous with being a market maker. The liquidity provider (LP)facilitates the trading of assets in the financial market; in this case the crypto market. The process of liquidity providers enables LPs to facilitate cryptocurrency trading by pooling equal amounts of two different cryptocurrencies so that the buyers and sellers can trade between the two different cryptocurrencies. 

The liquidity pools on the decentralized exchanges (DEX)  are set up by automated market maker-based models to facilitate the trading of illiquid trading pairs with limited slippage. These automated market makers are a noteworthy revolution in blockchain technology that permits on-chain trading without the need for an order book.

Order book-based exchanges (centralized exchanges) can be problematic for trading illiquid pairs. The reason being the disparity in the bid/ask prices during the execution of trades can ultimately lead to greater slippage. With liquidity providers, trades can be executed provided the liquidity pools are big enough. Liquidity providers in the market facilitate trades and get paid transaction fees on trading activity.

It is important to note that liquidity providers earn transaction fees based on the proportion of cryptocurrency they supply to a liquidity pool. When funding the liquidity pool, the LP has to provide the equal value of the two different cryptocurrencies, this creates a trading pair that enables buyers and sellers to trade between the assets, For example, a liquidity provider supplies a liquidity pool with $5,000 worth of MVI and $5,000 of ETH on a DEX likeUniswap,  on the execution of any ETH/MVI trade on Uniswap the LP will earn a percentage of the trade-in transaction fees based on the $10,000 ETH/MVI liquidity provided. 

Benefits

Liquidity is a key feature of arbitrage (buying and selling of financial assets). It indicates the viability and efficiency of an organization because the availability of liquidity in sufficient amounts at all times ensures that the organization can meet their due obligations and execute transactions on the exact moment they are due, otherwise, it stands being stated as illiquid.

In the traditional financial systems, banks act as the major financial intermediaries accumulating large pools of liquidity and funds for different groups within the system. They are expected to provide adequate liquidity for efficient daily financial operations. This enables them to charge fees for transactions. The same applies in decentralized finance as the market-making process by liquidity providers replaces the traditional order book model used by centralized cryptocurrency exchanges, which is a replica of the conventional financial markets. In Defi, the market makers’ role is primarily to ensure that there is an equilibrium between the demanding buyers and the supplying sellers, to effectively keep prices at a fair value by contributing liquidity.

While the provision of liquidity guarantees returns on every transaction, the rewards of all liquidity pools are not equal – some of the liquidity pools offer more rewards than others. It's imperative to work with this information as a vital tool to maximize participation in any liquidity provision. Liquidity providers are always faced with the dilemma of constantly allocating their assets within different pools to maximize returns from the variation in APY.

Brief Step by step guide as to how to become an MVI/ETH Uniswap LP

Providing Defi liquidity doesn’t come with a one-size-fits-all approach. However, to provide liquidity on Uniswap, the first step is to set up an account on the platform, then synchronize an Ethereum wallet such as MetaMask or any other Web 3.0 enabled wallets. On completion of the previous steps, the tokens can be deposited into the preferred liquidity pool.

Uniswap makes it much easier as the LP can search for the MVI/ETH liquidity pool where they want to provide liquidity and then connect the Ethereum wallet. Like we stated earlier, the LP needs to check for variables like returns, the exchange rate, and the pooling ratio before depositing the tokens into the liquidity pool.

Here is a table that provides a comparison of the MVI/ETH Liquidity pools

Liquidity Provision Platform

Liquidity Pool Size

APY (Since Inception)

Fees

Additional Rewards Expected annual return per $1000 (122 Days)

Uniswap

$6.51M

7.51%

0.30%

$1,025

How to manage your MVI position

APY Vision is an all-in-one dashboard that provides liquidity providers real-time access to monitor and manage their pools and keep track of impermanent Losses and Gains. It supports the commonly used decentralized exchanges; Uniswap, Balancer, and Sushiswap.

Another vital metric that can be used to effectively monitor the performance of your LP (MVI position) is the volume/liquidity ratio. The volume is a leading indicator of an asset's liquidity level. A lower volume or liquidity volume in this case indicates a low total market interest in that particular liquidity pool which will inform the liquidity provider of the decision to take.

Risks of LP’ing

Impermanent Loss; One of the downside risks of liquidity provision is Impermanent Loss. Impermanent loss is the difference of the value( in this case price) of the coins between entering into a liquidity pool position and keeping the coins in your wallet. As the allocation of the coin changes, the LP could end up with a less desired coin. An impermanent loss can be reversed or can lead to an irreversible massive decline of an asset.

Let’s consider an example. If an LP stakes 10 ETH and 100 MVI in their respective Uniswap pools and a week later, 10 ETH is equal to 2000 DPI, he would realize that If he kept his initial 10 ETH and 100 MVI, in his custodial wallet, he would have gained 50%. By participating in the Uniswap liquidity pool, his gain is less than the 50% that would have been made by simply holding onto his asset.

Market Risk

The price of assets is largely determined by market activities hence, the (in)stability of the market can hurt or improve the performance of any asset. Market risk can result in losses on financial investments. Examples of market risk are the variation in asset or token prices and regulatory changes.

Smart Contract Risk

Recent events have shown that no system is exempt from imperfection. From risks such as operational bugs, internal risks, and design errors, the smart contract of the liquidity pool can be fraught with error because the Defi system is a weave of networks that are interconnected through interminable smart contracts created by different developers.

Conclusion

For anyone interested in these platforms, DYOR (do your own research) remains the recurring theme. The LPs must consider the risks listed above as cardinal, while also taking into account the tokenomics and other intrinsic concepts like how liquidity affects returns, the volume/reserves ratio ( the higher the volume/reserves ratio, the higher you earn), trading volume, swap fee, Liquidity pool reserve size, age of liquidity pool (The older a pool is the lesser the risk).