What Kinds of Liquidity Providers Rewards Are There?

Automated Market Makers (AMMs) were discussed by Vitalik Buterin in 2017 and one year later introduced by Uniswap on Ethereum. That's the early days of decentralized exchanges. So far, I haven't heard of another DEX concept that doesn't involve AMMs and liquidity pools, but maybe that time will come...

Instead of trading pairs and market makers providing liquidity, as on traditional markets, AMMs have liquidity pools. Anyone can provide liquidity to a pool. But why would they do it? Market makers in traditional markets are paid to do this service. It is normal that liquidity providers receive some kind of reward for allowing others to swap assets using their tokens. Otherwise, they can as well do something else with those tokens that is more profitable. Remember, we are talking about an open system with anyone being able to participate. It's not only the owners, developers and people who love certain projects who provide liquidity, in an ideal scenario.

Rewards for Providing Liquidity

The most common type of reward for providing liquidity to pools is represented by a share of the swap fees. That's how Uniswap V1 incentivized its liquidity providers.

Source - Nope, not this kind of pool! 😀

In my opinion, this is the best rewarding option for providing liquidity. It may not be easy to calculate an APR, because swap fees fluctuate, but it's not inflationary and it doesn't require external incendivization. It's self-propelling by the swap volume in the liquidity pool.

Regarding fees paid out to LPs, I generally like the ones that autocompound as shares in the pool, and not as much the ones that are paid when you withdraw liquidity. But sometimes this has to be adapted based on the kind of fees that the main chain has.

Not all liquidity pools are lucky to be so active and liquidity providers willing to keep their funds in, without a guaranteed reward pool, that doesn't vary with trading volume.

However this system of additional incentives is conceived, it comes to drawing down from a source of inflation somewhere. For example, on Hive-Engine, anyone can add rewards to any pool. But those rewards are finite, need to be refilled when the supply ends, and they come from somewhere: personal holdings, project holdings, inflation set aside especially for diesel pool rewards (Splinterlands pools).

Before that, we had a certain model of Defi platforms that all had inflationary platform tokens paid out as rewards to liquidity providers. That model proved to be a failure, despite different types of attempts to keep it alive, because people sold the platform token into the ground to compound into liquidity pools involving major coins, or simply extracted out of the platform. Nowadays, I believe there are only a few major platforms left using this old model, but heavily modified compared to the beginnings.

Another way LP providers can benefit is if a snapshot of holdings in such a pool is taken for an airdrop or claimdrop.

An important novelty was introduced with Uniswap V3, and that is the concentrated liquidity, and a tiered fee system. We can find it outside EVMs too, for example on Osmosis in the Cosmos ecosystem as Supercharged liquidity.

That allows a major boost in capital efficiency, if it is well used.

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Posted Using InLeo Alpha