What is Staking and LP Staking? | The Basics
We give a quick overview of this important topic on the DeFi (decentralized finance) and cryptocurrency space. It’s designed for beginners! Watch the video version. Text transcript is below.
So, what the heck is staking crypto? In a nutshell, you are banking your cryptocurrency in exchange for an APY, an annual percentage yield, just like you would with an interest-bearing savings account in a bank. Someone is offering you x percentage a year for them to hold your cryptocurrency. However, cryptocurrency projects will often offer much greater APY than anything you could ever get in a bank. The caveat being the “yield” you generate will be in the form of cryptocurrency or tokens.
In basic staking, the primary thing that happens is you give your tokens or coins to the network, ether on your own or through someone else, and the crypto you gave usually is used to form nodes to validate the network. You get rewarded for that with intermittent rewards of currency. Avoiding diving too deep into network validation methods, for all intents and purposes you temporarily no longer have access to your currency — and as thanks you get more currency.
Liquidity pool or “LP” staking is a little bit different. For context, the stock market uses companies called Market Makers to facilitate transactions. They are an intermediary buyer/seller that keeps the market liquid and flowing. However, the DeFi world uses Automated Market Makers. Using BLOCKCHAIN TECHNOLOGY the process of verifying who owns what in the pools can be totally autonomous and consensus based.
So, what is a liquidity pool? The analogy that turned the light bulb on was this one: All markets involve pairing one asset with another. In the US stock market shares of companies like…say… Microsoft are paired with their equivalent value in USD. In DeFi liquidity pools, liquidity providers are pairing one token or coin with another.
The pair is usually between some token that does a thing (the product or company, in the previous analogy) and a well-known crypto asset like Ethereum (The big mother currency for most DeFi) or USDT (An Ethereum token that is always worth one USD), but technically it can be any pair. Something to keep in mind though, if you don’t pair your token with one of the standard trading mediums then there will be considerably less demand for your pool. It would be like pairing shares of Microsoft with shares of Uber. There could be somebody that wants to trade those two things, but why not just go from Microsoft to USD, then USD to Uber?
The market maker can draw on the resources in the pool to exchange one token or coin for its partner which lets the market flow. On Uniswap, which is a well known and simpler DEX, (Automated market maker in the DeFi space) the pool generates a .3% transaction fee for every… well transaction. Uniswap has a natural dark mode and a synthwave palate as well. Which I think is fashionable.
Yeah that’s cool, but how the hell do I get my profits? How do liquidity providers reap their reward from the pools? To show who has ownership in the pool, the DEX platform generates a fungible token that works like a receipt when you deposit money in the pool. It’s a token in its own right. You could sell that receipt to someone else if you wanted to. Ownership of the sacred LP tokens attached to the pool gives you proportional ownership in both the assets in the pool and fees generated by the pool according to the ratio of how many relevant LP tokens you own vs the total number of relevant LP tokens currently in existence.
Here is an example to clarify that word salad of a sentence above. Sally starts a liquidity pool of two tokens and according to the formula for that pool, her liquidity deposit earns her 10 LP tokens. There are only 10 tokens that exist, she owns all of them, she gets 100% of the fees and owns 100% of the liquidity.
Billy big shot rolls in and pours in 10x her amount of liquidity into the pool and gets 100LP tokens. There are now 110 tokens. Sally has 10/110 tokens or 9.1% ownership. Billy has 100/110 tokens or 90.9% ownership.
Finally, to extract fees and assets you have to destroy the LP tokens. They get burned, you get the chunk of pool feels you earned and your crypto back. Everybody else now has a higher percent ownership in the pool. However, due to supply and demand shifting the proportions of tokens in the pool, you might not get the same amounts of each that you deposited initially. Broadly speaking, liquidity providers reap the best rewards when there is a very large volume of trades but the average “price” doesn’t change.
There are additional bonuses to LP staking like staking the LP tokens themselves. There is a lot to say about the topic but that is probably enough for now. If this was something you are interested in, comment down below and we’ll make another video going in depth about some aspects that we breezed over. We’ll have a video soon with an example of someone staking in an LP pool on Uniswap and the steps involved in that as well as staking LP tokens.
