A liquidity pool refers to a *pool* of tokens being held in a smart contract¹ and is used for trading between assets on decentralized exchanges, such as Uniswap or Curve. Liquidity pools can serve more than one function in the decentralized ecosystem, including providing liquidity to spot traders, perpetual exchanges and bridges. The common denominator to liquidity pools is that you are providing tokens to a smart contract, which enables its functionality and rewards you for your contribution to the pool. Learn more: What is a Liquidity pool? Uniswap Labs
When you provide liquidity to a pool you are allowing the smart contract to use your tokens, in return, the contract will give you back Liquidity Pool tokens, which you receive to your wallet and hold in self custody. LP tokens² are the wrapped version of your assets once they enter the liquidity pool and represent your stake, you can imagine an LP token like a receipt, in that you must return the LP to withdraw your tokens.
When you enter a dual asset liquidity pool³, like AAVE/ETH, you enter the pool at a 1:1 ratio; This means if I want to provide $1000 to the pool, I will need $500 of AAVE, and $500 of ETH. LP tokens are tied to the price of underlying assets, if the price of both assets increase simultaneously the price of your LP token will increase and if they decrease simultaneously the price of your LP token will decrease. If asset prices diverge, the original 1:1 ratio will fluctuate and cause impermanent loss, which we get into below.
AAVE/ETH Example: If I provide $500 of ETH and $500 AAVE to a liquidity pool contract, I will receive back $1000 in the amount of AAVE/ETH LP tokens relative to my percentage of the total pool. These LP tokens represent my 1:1 stake in the ETH/AAVE pool. Watch the attached 2 minute video, "Providing Liquidity and DeFi Staking for Beginners" to see a simple walk through of this example with visual aid.
¹Smart Contracts are self executing lines of code running on a blockchain, the concept of a smart contract is the same as any contract format you would be familiar with, two parties come to an agreement, sign a contract and execute. With smart contracts, agreements can be made autonomously and anonymously with no intermediary. Learn more: What are Smart Contracts?, Blockgeeks
²LP tokens LP is an acronym for Liquidity Pool, liquidity pool tokens represent your contribution and stake in the pool relative to total pool size.
³Dual Asset Liquidity Pool refers to a liquidity pool made up of two assets, the AAVE/ETH LP is a dual asset pool. There are also single asset pools, meaning a liquidity pool made up of one asset, if I stake USDC as a single asset, it is in a single asset pool.
Liquidity providers are incentivized with "Liquidity Rewards", these rewards however, are not to be mistaken with "Staking Rewards", if you've watched the above video clip, you should already understand this concept. If you skipped over the video clip and feel confused at this point in the text, please go back and watch it.
Once you have provided liquidity to the pool and received your LP token, you have the option to stake your LP token in a protocol, the process of earning staking rewards is what is typically referred to as "Yield Farming".
Liquidity Rewards are fees that are distributed to the liquidity providers as rewards for their contribution to the pool; these rewards will accumulate within your LP token, you do not need to stake or harvest to receive liquidity rewards.
Staking Rewards are incentivized rewards provided by a protocol or blockchain to encourage user participation. There are several different models to staking rewards mechanisms including inflationary tokenomics and fee distribution. Staking rewards from fee distribution are generally safer and more sustainable models. Pools that are eligible for liquidity rewards will continue to accrue rewards in the LP on top of any staking rewards. Learn more: Beginners Guide to Staking, Zerion
In order to provide liquidity and farm tokens for staking rewards you will need to complete a set of smart contract interactions⁴. On the user end these are simple clicks, every smart contract interaction costs a gas fee and every smart contract interaction executes an approval or function.
The following process is only 5 clicks on the user end:
There are three smart contract interactions necessary for liquidity provision in a dual asset pool; first you must submit two approvals, one for each asset you want to contribute to the pool. These approvals allow the protocol to interact with your tokens, the third interaction will execute your request to pool tokens into the LP. Similarly if you want to then stake your LP, you will need to approve your LP tokens to allow the protocol to interact with them before you can execute the request to stake.
⁴Smart Contract Interactions enable your ability to interact with the web3 world, every smart contract interaction is an approval or request to use a decentralized protocol.
Using an AMM interface with your web3 wallet to provide liquidity and stake, these are the contract interactions you will be prompted with, they each require 1 click from you in your web3 wallet.
Using the AAVE/ETH Example from Earlier:
You have AAVE and ETH in your wallet. Go to the "pool" page of your AMM to select the tokens you want to provide liquidity with; in this case, AAVE and ETH. One you have selected your tokens, you will be prompted to submit contract approvals to provide your liquidity to the LP.
You now have your LP Tokens. Go to the "farm" page, or third party farm you want to use to stake your LP tokens. Navigate to your LP pairing page on the farm, once on this page you will be prompted to submit contract approvals to stake your LP tokens.
Your LP Tokens are now staked.
Using a AMM interface with your web3 wallet to unstake and remove liquidity from the pool, these are the contract interactions you will be prompted with, they each require 1 click from you in your web3 wallet.
Using the AAVE/ETH Example from Earlier:
Return to the "farm" page from the protocol you staked your LP tokens in.
Your LP Tokens are now back in your wallet. Return back to the AMM where you originally provided liquidity to withdraw your tokens from the LP. Navigate to your LP pair, once on this page you will be prompted to submit contract approvals to unstake your LP tokens.
You have now have your AAVE and ETH back in your wallet.
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Decentralized Finance is subject to significant risk, including risk related to smart contracts.