There are probably thousands of articles out there explaining liquidity pools and governance tokens. So right off the bat, here are the top reasons why you should be reading THIS, and NOT the others:
I've been in the thick of things contributing to various DeFi projects since late 2020. So you can expect to get some real investment insights (not advice) backed up by on-chain data and personal experience.
I'm a nice guy. I don't lie.
Now that you are convinced to read this let's get right into it.
Unlike most DeFi instruments, there's more to liquidity pools than just being decentralized. For example, a traditional exchange runs on a central limit order book design. So put, buyers come and place a bid price on one side, and on the other side, sellers place an ask price. Finally, when the bid-ask prices meet, the trade happens. As you can imagine, this design requires much liquidity for efficient functioning. That's why a long tail of assets get unfairly underpriced because of lack of liquidity.
This is what decentralized exchanges (DEXes) based on liquidity pools seek to solve. For example, let's take a liquidity pool consisting of token A and B. At one end, liquidity providers add tokens A and B in return for LP (liquidity provider) tokens. At the other end, traders can come and swap token A for token B and vice-versa at a certain fee. This trading fee gets distributed amongst the LP token holders according to their contribution to the liquidity pool. Compared to a traditional exchange, liquidity pools work very well for the long tail of assets in terms of attracting liquidity.
So to answer your question, you can earn passive income from liquidity pools via trading fees by simply depositing crypto assets into a liquidity pool. A few good DEXes host liquidity pools to invest in, such as Uniswap, Orca, etc.
The next logical question is how much you can earn from this. Thankfully, it's possible to value liquidity pool investments using traditional financial models such as DCF. So valuing them should not be a big deal.
This chart represents the growth in trading volume for DEXes since January 2019. Although the recent trading volume has gone down because of the bearish market sentiments, the trend that jumps out is that the monthly trading volume for June 2022 has doubled to $60 billion from $29 billion for September 2020. This number will undoubtedly breach more milestones as more and more crypto projects find their product-market fit and onboard more users and liquidity.
Let's do some quick math:
Uniswap's Monthly Trading Volume = $40 billion
Uniswap's Annual Trading Volume = $480 billion
Uniswap charges a 0.3% trading fee on every swap.
So, Annual Revenue Via Trading Fees = $1.4 billion
Uniswap's TVL stands at around $5 billion. Let's assume you invest $100k in one of Uniswap's pools.
Your share in it works out to be 0.002%.
Therefore, your annual yield = $28,000
There you have it! That's a 28% APY on your capital!! Also, you might as well add a few more dollars to it as specific DeFi protocols also allow you to stake your LP tokens to earn more yield. Back to the topic, the nature of this yield is completely sustainable as it is generated from the cash flows of Uniswap and not via an inflated liquidity mining reward program. As for the risks, like anything DeFi protocol, there are certain smart contract risks associated with liquidity provision. Granted, protocols can get their codebase audited, but that doesn't reduce the risk to zero. That's why it's highly advised that you get insured for your capital invested.
Sushiswap was the first DEX to add governance tokens to its protocol. This move found much favor with the users. So much so that Sushiswap drained nearly $1 billion from Uniswap in 2020. Later, however, Uniswap regained its lost position– that's a story for some other article in the future.
What was so magical about this was that it caused $1 billion in user liquidity to switch protocols in no time. At their core, governance tokens give their holders voting rights over the protocol's governance. However, when staked, governance tokens also allow investors to boost their returns. That's why these tokens hold significance for LP owners/DeFi projects. They leverage governance tokens to attract liquidity by voting for more boosted rewards for their pools relative to others. Curve Wars is a perfect example of this strategy employed by the DeFi protocol.
Difference Between LP Tokens & Governance Tokens
These tokens represent the ownership of assets in the liquidity pool.
These tokens represent the right to vote on and pass governance proposals over the protocol.
Typically these tokens generate more yield.
These tokens generate comparatively less yield.
LP token yields are sustainable.
Governance token yields tend to be unsustainable as they are generated through supply inflation.