AMM Liquidity Pool Tokens: Novel Assets in Decentralized Finance

How to get paid yield on your crypto assets.

Uniswap and other AMMs incentivizes liquidity providers, in other words, people who deposit ERC20 tokens into the smart contracts on their platform in order to make sure there is always a supply to buy from.

In this article, you will learn about Uniswap, how it works, and how you can leverage your rewards.

What is Uniswap and how does it work?

Uniswap is a fully decentralized, Ethereum-based protocol that provides automated market making based on a simple functional formula. It is built upon a system of non-editable smart contracts.

The smart contracts describe and control both the rules for the liquidity pools and the rules for Uniswap as a decentralized autonomous organization (DAO). A liquidity pool can be created for any two ERC20 tokens, and the related currencies can be swapped with each other according to the platform’s formula.

The advantages of this decentralized exchange protocol are clear:

Uniswap allows self-custodial management in contrast to conventional central stock exchanges. There is no “Know Your Customer” (KYC) process, which means increased anonymity for Uniswap users. Furthermore, Uniswap has significantly lower trading fees.

The Uniswap fee is just 0.30% for each exchange. Of this amount, 16.6% is paid in the Uniswap protocol itself and the remaining 83.4% goes to reward those who provide the liquidity of the pools.

How can you collect some of these rewards fees?

If you deposit two ERC20 tokens into a pool on Uniswap, this is called a liquidity-providing transaction. For each liquidity-providing transaction, you automatically receive Uniswap liquidity provider tokens (LP tokens). These tokens track your contributions to the pool and are used to distribute your share of the transaction fees incurred during the period for which you provide liquidity.

When you take your liquidity out of the pool, the LP tokens are used to calculate your share of the fees through a smart contract. These fees can then be paid out in one of the two currencies you originally deposited.

How do you get there?
Walkthrough — Adding Liquidity Through Uniswap

We will go through these steps using the example of the ETH/DAI trading pair:

1. Go to https://uniswap.exchange (make sure you are logged in to MetaMask or any other Web3 wallet).
2. Click “Pool” to go to the Liquidity Adding Interface.
3. Then click “Add Liquidity” on the left side above the “Deposit” field (this drop-down box is also where you can remove liquidity).
4. Uniswap now shows the balance of your connected ETH wallet and the ERC20 token you select in the drop-down list below. It also shows the exchange rate and your share of the liquidity pool. This share also determines your portion of the payout.
5. If you enter a value for either ETH or DAI, Uniswap will automatically fill in the correct amount of the other asset based on the current exchange rate. Remember that you add liquidity by contributing the same value for one ERC20 token and another ERC20 token.
6. You can click on “Transaction Details” for more information, including the number and value of the liquidity tokens you will be minting.
7. Then click on the blue “Add Liquidity” button. If you are using the MetaMask, adjust the gas if you wish and then click “CONFIRM” in the window that opens.
8. Once the transaction has been confirmed on the Ethereum blockchain, you are done! The interface displays your updated ETH and DAI balances and your share of the trading pair’s total liquidity pool. You continue to earn a portion of the 0.3% fee on all transactions between ETH and DAI until you remove your liquidity.
9. You can then add the LP token pair directly to your metamask, and you’d see your LP tokens.

What pools can you invest in?

The ETH/DAI trading pair was of course only an example. Instead of this pair, you could invest in a pool with two other ERC20 tokens or even open your own pool if you have tokens for which there is no pool yet.

In the first case, we recommend using tools such as pools.fyi and uniswap.info to keep track of which pools have the highest returns, volume, and liquidity at any given time. This is because the profits to be achieved can depend heavily on these factors.

In the case of opening a new pool, only point 3 of the previously described walkthrough must be changed to the following:

3. Click “Create a pair” on the left side above the “Deposit” field.

In the following steps, the process no longer differs.

You can now get shares of the fees generated from transactions in your pools with your ERC20 token pair.

Summary

In this article, we demonstrate that Uniswap is a protocol for the decentralized exchange of tokens on Ethereum, allowing anyone to quickly exchange between one ERC20 token and another ERC20 token, and additionally earn fees by providing liquidity.

We further explained that each liquidity provider will be paid their share of the fees depending on their share in the pool.

The process of completing this was broken down into individual steps.

With this process demystified, it is our hope that users will use these instructions to put their digital assets to work.