DeFi: AMMs, Liquidity Pools, and Yield Farming Risks

In this episode we explain the core concepts of DeFi (Decentralized Finance), focusing on Automated Market Makers (AMMs) which power trading on decentralized exchanges through liquidity pools. Users called Liquidity Providers supply these pools with tokens, earning fees in return. This foundation enables yield farming, where users employ various strategies, often involving AMMs and liquidity pools, to generate additional cryptocurrency rewards. However, the text also highlights significant risks associated with DeFi, such as smart contract vulnerabilities, rug pulls, asset volatility, and impermanent loss, urging users to conduct thorough research before participating.

• What are Automated Market Makers (AMMs) and how do they differ from traditional cryptocurrency exchanges?
• How do AMMs function through the use of liquidity pools, and what role do Liquidity Providers (LPs) play?
• What is yield farming, and what are some common strategies employed by participants?
• What are the significant risks associated with participating in yield farming?
• How are Automated Market Makers (AMMs), liquidity pools, and yield farming interconnected within the DeFi ecosystem?

Glossary of Key Terms

• Automated Market Maker (AMM): A type of decentralized exchange protocol that uses a mathematical formula to price assets and automatically facilitates trading between users through liquidity pools, without relying on traditional order books.
• Decentralized Finance (DeFi): An emerging financial system that uses decentralized technologies, primarily blockchain and smart contracts, to provide financial services without the need for traditional intermediaries like banks and brokerages.
• Decentralized Exchange (DEX): A cryptocurrency exchange that operates in a decentralized way, allowing users to trade directly with one another without a central authority or intermediary holding their funds.
• Impermanent Loss: The potential loss of value for liquidity providers in an AMM when the price of their deposited tokens changes compared to when they deposited them, measured against the value if they had simply held the tokens. This loss is unrealized unless the liquidity is withdrawn while the price difference persists.
• Liquidity Pool: A collection of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trading on decentralized exchanges and other DeFi protocols. These pools are funded by liquidity providers.
• Liquidity Provider (LP): A user who deposits an equivalent value of two different tokens into a liquidity pool on an AMM to facilitate trading. In return, they typically earn a share of the trading fees and receive LP tokens.
• LP Token: A token issued to liquidity providers in an AMM representing their share of the liquidity pool. These tokens can often be staked for additional rewards or used to reclaim the deposited assets plus accrued fees.
• Smart Contract: A self-executing contract with the terms of the agreement directly written into code. These contracts are stored on a blockchain and automatically execute actions when predefined conditions are met, forming the backbone of DeFi applications.
• Token Swapping: The process of exchanging one cryptocurrency or token for another on a decentralized exchange, often facilitated by the liquidity within an AMM's liquidity pools.
• Yield Farming: The practice of lending or staking crypto assets across various DeFi protocols to generate returns or rewards, often involving providing liquidity to AMMs and staking the resulting LP tokens.