This is the latest version of Uniswap (V3), and it appears quite a bit more complicated than previous iterations.
We start off by selecting the two cryptocurrencies we want to add to a pool (top left). In this case, it is ETH and USDC.
Next, we select a fee tier. Naturally, you may want to select the highest fee tier; but there may be little to no action here. Why would a trader pay 1% if they can pay 0.3% to trade a pair?
Generally speaking, pools with similar cryptocurrencies within them (like two stable coins), will see the most action (and fees) in the 0.05% tier. Dissimilar crypto pairs (like wrapped bitcoin and wrapped ether) will fall into the 0.3% tier and exotics will fall into the 1% tier.
You can read more about the tier fees in this great Medium article.
Next up, you choose a range that you want to provide liquidity for (the pink chart). You can read more about ranges here.
After you have successfully contributed two cryptocurrencies of an equal value to a liquidity pool, the Uniswap protocol will give you liquidity provider tokens (LP tokens), which represent your stake in the liquidity pool. These tokens are also used to distribute your rewards for being a liquidity provider.
If you no longer want to be a liquidity provider, you simply cash in your liquidity tokens and get your crypto back (+ the fees you made!). The number of your tokens will be different from when you started the pool, but their value will be the same.
3 DeFi Risks
It is impossible to earn a return in this world without taking on some degree of risk. DeFi is no exception to this rule. Here are the top 3 risks that come with investing in DeFi.
1. DeFi Software Risks
There is always a chance that the DeFi protocol you are using has faulty code or bugs. To mitigate these risks, it is best to make sure independent audits have been performed on the protocol’s smart contracts.
TempleDAO, a yield farming DeFi protocol, was hacked in October of 2022 for 2.3 million dollars. The hacker found vulnerabilities in the protocol’s smart contracts.
2. Counterparty Risk
Whenever you lend anything, there is always counterparty risk. DeFi protocols generally require collateralization ratios of greater than 100%, which helps to mitigate this risk.
Counterparty risk in crypto may occur in very volatile markets when keepers can not liquidate undercollateralized loans in adequate time.
3. Crypto Token Risk
Token risk is a fundamental risk of DeFi that no investor is immune from. This risk involves the actually cryptocurrencies you are using on a DeFi protocol, not the protocol itself.
For example, if you are lending out a US dollar stablecoin on Aave, there is a chance that your stablecoin could lose its peg.
This happened with the TerraUSD (UST) algo stablecoin in 2022. This coin lost its peg in mid-2022 and is now trading for less than a penny.
In addition to making sure protocols have been adequately audited, it is, therefore, necessary for crypto investors to also make sure the crypto tokens they are using are safe and reputable. For stablecoins, this may require you to make sure that the stablecoin is actually backed by US dollars, and not backed by algorithms, which was what backed TerraUSD.
If a DeFi protocol is offering ridiculously high payout on tokens you have never heard of, there is usually a reason why. Always research cryptocurrencies before trading them.
📕 Read Next: Best Ways to Invest in Web3
*Please bear in mind that DeFi participants must pay gas feeson all Ethereum transactions. These fees are charged by the network in order to add your transactions to the blockchain.
Happy trading!
