My DeFi diary — day 7: from liquidity pools to liquidity mining

This series is a look back at the last few months as I’ve made my way into the crypto space, and particularly into the DEFI space, as a complete newbie. I aim to catalogue the moves I’ve made, the tech I’ve experimented with, and the mistakes I’ve made along the way. I include some details around fees and logistics, hopefully to be useful to others wanting to follow in my footsteps.

29 April 2021 04:56 ETH @ $2,758.46 Gas Price: 45 Gwei

In my last diary entry, I described liquidity pools, and the process I followed of entering a liquidity pool via Zapper.fi. In this post we look at liquidity mining, in some ways a logical next step after depositing crypto into a liquidity pool.

Let’s start by looking at what happened next when I deposited my ETH and MATIC into the ETH-MATIC liquidity pool on Uniswap. In return for my deposit, I was issued with a certain number of liquidity pool (LP) tokens. In some ways this is like the guy at the coat check handing you a ticket when you give him your coat. But in this case that ticket is a token in its own right, so it has a value, and can be transferred or traded around as well.

On this particular transaction I was issued 110.53 UNI-V2 (Uniswap V2) tokens. You can see those UNI-V2 tokens being minted and then transferred to my account on Etherscan here and below:

Now I could choose to just hold those UNI-V2 tokens and hope to earn decent fees from my liquidity pool deposit. Or, I can choose to engage in liquidity mining by staking those tokens and earning further returns. The terminology here can start to get a little bit confusing and inconsistent — often times I stake my tokens into a ‘farm’, and then in return for staking those tokens I am issued with yet another set of tokens. Let’s look at this in practice to try to demystify it a little.

In the next two transactions on my account, I first approve a contract called BaoMasterFarmer to transfer my UNI-V2 tokens (transaction fee $5.86), and then I deposit my UNI-V2 tokens with that contract (transaction fee $57.90). In my case I did this all via Zapper.fi, on their farm tab. I chose this particular option because the ROI on the farm looked very appealing on Zapper.fi, for the particular liquidity tokens that I had to stake.

This is what the ROI for that particular farm looks like right now:

Not very good at all — only 0.41% per year! And the liquidity in that particular farm has dropped down to $141k, not very much at all. Compare that with some of the insane return numbers in the top returning farms at the moment:

So, this highlights a couple of key points. The first is that these return rates can change dramatically. I entered the MATIC-ETH farm just over a month ago, and the return rate was much higher (around 60% if I remember correctly), but it has dropped right down. So if one wants to do well in liquidity mining, you’ve got to be willing to play quite an active role, monitoring return rates and being prepared to move your crypto around to chase good returns.

But this introduces an element of challenge, as the transaction fees can cut into your returns in quite a serious way (depending of course on the quantum of money that you’re investing — remember the fees are not a percentage, they’re flat fees per transaction).

The second challenge is that sometimes you will be penalised if you ‘unstake’ your staked coins too soon. After all, the very point of the staking is supposed to add to the stability of a certain protocol because they can rely to a degree on that amount of liquidity being locked up for a certain amount of time.

So this is where the terms yield farming and crop rotation come from (see here for a great youtube explainer on yield farming from Finematics — their other videos are definitely worth checking out as well). Those who are active in the space are constantly looking for good yield opportunities, and then rotating their crops (moving their crypto) into those opportunities. There are also aggregators, like yearn.finance, who look to do some of this work for you.

To finish off the transaction that I made, the BAO tokens that I was issued by the farmer are, again, tradable crypto tokens. You can see a price chart for them here:

So there’s an almost infinite possible regress here — of depositing ETH and MATIC for UNI-V2 tokens, and then staking those UNI-V2 tokens for BAO, and potentially then staking or trading or doing something else with those BAO tokens.

I would definitely end this section with a warning. Just like there are risks (mainly of impermanent loss) of entering a liquidity pool, there are also risks associated with staking your LP tokens — in particular, check out the farmer that you are using (a good start is to look at their price chart, their market cap, and any news stories about them), check what rewards are associated with staking with that farmer (farmers run rewards programs from time to time, which can be a great way to boost returns), and finally check what the penalties are for un-staking early.

As with almost everything in the financial world, high risk and high reward are usually coupled together, so if you see a very high ROI on something, do the work to understand what risks are coupled with that reward.

In my next post we’ll look at how I looked to get away from the high transaction fees on the main Ethereum network, and after that we’ll look at some of the good yield farming opportunities that exist on the Polygon network. Stay tuned!

Got any questions or comments? Pls post below — keen for this to be a two way conversation!