By depositing token pairs to Raydium liquidity pools, users can act as liquidity providers and earn passive income from trading fees. There are standard liquidity pools and concentrated liquidity pools, with the latter enabling greater capital efficiency and higher APRs, although they require more active management by comparison with standard pools.
If you’re looking at ways of earning in DeFi, contributing to liquidity pools is a valuable option. The process is relatively straightforward, so let’s get an overview of how liquidity pools work, and then go through how to deposit to concentrated Raydium liquidity pools on Solana.
Before we get started though, keep in mind the risks involved: as with all DeFi activity, there is the danger of smart contract vulnerabilities, and the possibility of extreme market volatility. Also, a particular risk factor to consider with liquidity pools is impermanent loss, which we’ll cover below.
What Are Liquidity Pools and How Do They Generate Profit?
Decentralized protocols can’t use a centralized order book system, as you’d find in a regular exchange, and so liquidity pools are used instead.
These pools each hold two different tokens in a trading pair, enabling users to trade by simply dipping into the liquidity provided, while algorithms adjust prices according to supply and demand.
A big advantage is that anyone can contribute to a pool, and by doing so you become a Liquidity Provider (LP), meaning you’ll earn a cut of the pool’s trading fees in amounts relative to your deposit. So, it’s fees that generate profit, and LPs–meaning anyone who deposits tokens–can share in that profit.
Standard or Concentrated Liquidity Pools?
With a standard pool, the liquidity you provide covers trades at any price, but in a concentrated pool you can specify a price range within which you will provide liquidity, in order to improve capital efficiency. So for example, you might decide only to provide liquidity within 10% either side of the current price if that’s where prices are ranging.
If price moves out of your range, you won’t earn anything from fees, but within your range, because your liquidity is concentrated you will earn more than you would in a standard pool. In short, this means your APR is higher, but only when price is within a set range, outside of which earnings drop to zero.
Keep in mind also that as price moves, the ratio of the tokens in your deposit will alter. So as an example, if you started with a 50/50 split of SOL and BONK, and the price of BONK dropped, you’d find yourself with more BONK tokens than SOL tokens if you closed your position at that point, and vice versa. And if the price moves out of your range entirely in a concentrated pool, your deposit will at that point have been converted entirely into only one token.
However, this is not bad as long as you’re comfortable holding either token, meaning it’s a good idea to provide liquidity in tokens that you actually want in your portfolio. And if, for example, you provide liquidity in SOL and a memecoin, and then the memecoin price rises and you’re left holding more SOL, you can view that as a kind of automatic profit-taking mechanism, whereby you’re gradually de-risking into the relatively more stable asset.
Impermanent Loss
Let’s quickly…
