How to Attract Liquidity for a DeFi Platform | 2022 Guide and Tips

Last Updated: May 15, 2022
Attract Defi Liquidity

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For a decentralized finance (DeFi) project to be significant and successful, it must attract enough liquidity to get things flowing and more people to join in. 

After all, liquidity pools are the foundational technologies behind the current DeFi ecosystem, which is a collection of funds locked in a smart contract.

Liquidity pools facilitate decentralized trading, lending, and many more functions, as unlike in centralized trading, in DeFi, trades are executed on-chain without any centralized party holding the funds.

For the buyer to make a purchase, there doesn’t need to be a seller at that particular moment. The only thing needed is sufficient liquidity in the pool. Here, the activity is managed by the algorithm governing all that happens in the pool.

Besides trading and lending, the implementation of insurance against smart contract risk is also powered by liquidity pools. Tranching is another way these are used as they allow LPs to select customized risk and return profiles.

Minting synthetic assets on the blockchain also relies on liquidity pools, as this is where the collateral is added before connecting it to a trusted oracle.

So, how can a DeFi platform attract liquidity? Let’s take a look at some of the options: 

Initial Boost 

The DeFi sector is constantly trying new things, and one way a DeFi project can attract liquidity is to provide liquidity by itself, in the beginning, to get the ball rolling.

They can use an auto-liquidity engine to inject liquidity into the project automatically. This liquidity could come from the token capital or the sDeFi project’s fees on every buy or sell order.

In March 2022, Stargate, a multi-chain bridge on the LayerZero protocol, auctioned off 100 million of its native STG tokens and used the proceeds to create the bridge’s initial liquidity.

It led to an increase in the project’s total value locked (TVL) to over $4 billion, which is spread across token pools on several blockchains, according to data tracking site DeFi Llama

Attractive Yield

Liquidity pools are the basis of automated yield-generating platforms where users add their funds to pools and use them to generate yield. Out of all the ways Liquidity pools are used, yield farming or liquidity mining is one of the most popular ones. 

Here, crypto projects distribute tokens algorithmically to users who put their tokens into a liquidity pool. The newly minted tokens are further distributed proportionally to each user’s share of the pool. These tokens can not only be native tokens but can also come from other liquidity pools called pool tokens.

For instance, if someone provides liquidity to Uniswap, they get tokens representing their share in the pool. These tokens may be allowed to be deposited into another pool and earn a return. 

So, to get liquidity providers (LP) to deploy their capital on a DeFi platform, it is vital to offer them some juicy yield.

At the same time, a DeFi project must make sure that it’s not just a one-time thing. In late 2020, at the peak of the DeFi bull market, the initial yields went through the roof only to decline substantially. 

While higher than average yield will help get LPs to join in initially, keeping the yield stable will ensure that liquidity does not vanish.

For instance, on the recently launched Stargate, traders have deposited their tokens with the platform to take advantage of the 20-25% yield it currently offers on stablecoins.

Impermanent Loss

When providing liquidity to an AMM, LPs suffer impermanent loss, which is the change in the price of digital assets.

And the more significant the difference in the price of crypto deposited, the more an LP is exposed to them. With crypto being a highly volatile asset, this permanent loss can be pretty huge at some point. 

Pools that contain assets that remain in a relatively small price range are less exposed to impermanent loss. Stablecoins, notably wrapped versions of a coin, stay in a rather contained price range, hence, a smaller risk of impermanent loss for LPs. 

Trading Fees

One way to counteract the impermanent loss is trading fees, which makes providing liquidity profitable. For instance, Uniswap charges a 0.3% fee on every trade directly to liquidity providers.

So, in addition to offering a high yield, can a DeFi project also set aside a percentage of the trading fees that they charge from a user for LPs. 

Moreover, suppose there’s a lot of trading volume in a given pool. In that case, it can be profitable for LPs to provide liquidity even if the pool is heavily exposed to impermanent loss. But, of course, this depends on the protocol, the specific pool, the asset deposited in it, and the market conditions. 

A Safe Protocol

While DeFi is revolutionizing finance, the sector struggles with hacks. The amount of money lost in hacks of DeFi projects more than doubled to $1.3 billion in 2021, according to Certik‘s “State of DeFi Security” research report.

Interestingly, centralization was the most common vulnerability in these hacks, which could have been avoided using multi-signature wallets.

A DeFi project must make sure that its protocol is safe and audited to attract LPs. Additionally, it is unwise for a handful of developers to have an admin key or some other privileged access within the smart contract code that allows them to control the pool’s funds.

It can make interested parties weary and reluctant to deploy their capital to a DeFi project. 

Final Word

Besides immediate results, for the long-term growth of the project, a DeFi protocol can introduce a product that encourages users to hold their tokens for a long time.

A high fixed yield of return (APY) for users to stake their tokens can also be offered. Making staking easy and safe and rapid interest payment are other ways to enhance contribution from users.

Additionally, ensure high reserves so that the pool is not subject to wild price swings and slippages and has several different liquidity providers instead of just a few whales not to affect the price ratios should big LPs exit the pool.

Having a DeFi project, token, and activities publicized in media and on-chain will also help attract liquidity to a DeFi platform. 

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