DEFI Works Kinda Like A Foreign Exchange Desk

Providing Liquidity in Fiat Currency

Imagine for a moment a currency exchange desk in the center of Paris. Everyday it must be prepared to handle thousands of conversions. Dollars→Euros, Euros→Dollars, Pounds→Euros, and dozens of other global currency combinations. How does that foreign exchange desk keep enough Euros, Pounds, and Dollars on hand? It relies on major financial institutions like domestic and international banks. They are called liquidity providers (LPs). Each time a traveler changes one currency into another in downtown Paris, LPs collect a portion of the fee charged.

Providing Liquidity in Cryptocurrency

The same principle is the basis of decentralized finance (DEFI), and DEFI is one of the main branches of the crypto asset class. Thousands of crypto trades occur daily. Ethereum→Bitcoin, Bitcoin→Ethereum, Ethereum→Cardano, and thousands of other combinations. As of August, 2021, 1600 cryptocurrencies have a market cap of more than $1 million, and 29 cryptocurrencies have a market cap of more than $1 billion.

The Opportunity for Small and Mid-Sized Investors

Unlike in downtown Paris, international banks and endowment funds are not yet supplying liquidity to crypto exchange services. Instead, regular investors with modest five, six, and seven figure liquidity positions on exchanges like Curve, Quickswap, Convex Finance, etc. are earning 20%, 30%, 40% and more on their holdings. This investment opportunity will last until big, institutional money enters the DEFI space. Goldman Sachs has already applied to the SEC for the right to sell a crypto exchange-traded fund (ETF). As institutional money prepares its paperwork, small-to-mid-level investors are capitalizing in the shallow waters.

Which Strategy Should I Choose?

You must determine the level of risk to which your portfolio will be exposed. For example, if you are bullish on Bitcoin (BTC) and Ethereum (ETH), you might invest half of your portfolio in each asset and begin providing liquidity to a Bitcoin/Ethereum pool. Every time another investor exchanges BTC→ETH or ETH→BTC, you will earn a portion of the exchange fees they pay.

What is Your Risk Appetite?

But what if you don’t want exposure to the price volatility of both Bitcoin and Ethereum? Instead, you may invest half of your portfolio in ETH and the other half in a stablecoin like USDC, which remains pegged to the value of the US Dollar. By supplying liquidity to an ETH/USDC pool, you earn a portion of exchange fees each time another investor swaps ETH→USDC or USDC→ETH. With this strategy, only 50% of your investment is exposed to market volatility, while the remaining 50% stays tethered to the US Dollar.

Conclusion

The cryptocurrency asset class is young. Rather than waiting for major liquidity providers like banks and hedge funds to enter the waters, small-to-mid-level investors are earning high APR while simultaneously positioning themselves for the water level to rise as bigger investors gradually enter the pool.

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