As the world of decentralized finance (DeFi) expands and evolves, new opportunities come with it. The option to invest your crypto in a liquidity pool is one of many ways to earn passive income on your assets.
In this article, we define liquidity pools and explain their importance in DeFi beyond just a lucrative opportunity.
What Are Liquidity Pools?
Simply put, liquidity pools are the funds of multiple people combined into a single inventory. They provide the decentralized market with quick and convenient liquidity for trades.
These pools are often cited as the backbone of crypto exchanges because they allow you to sell or purchase cryptocurrency without firms that provide the traditional market with liquidity (known as market makers).
Rather than having a market maker profit from the buying and selling of securities to satisfy the market, liquidity pools take a crowdsourced approach to accomplish a similar goal.
When several people combine and lock their assets, trades can automatically be facilitated on the exchange through automated market makers (AMMs). These alternatives to traditional market makers allow for the automated trading of crypto.
How Liquidity Pools Work
There are a few components that allow liquidity pools to function. These are:
- Liquidity providers
- A pool of funds
- A smart contract
- Incentivization for contributors
Each pool creates a new market for a particular asset pair. When you provide a pool with liquidity, you are depositing an equal value of two assets (regardless of how many tokens this equals for each) that are locked in a smart contract.
In exchange for staking in a pool, you earn an incentive in the form of liquidity provider (LP) tokens based on how much liquidity you have provided the pool with.
So, what happens once a pool is created and funds are deposited?
As we mentioned, liquidity pools involve a pair of tokens. These assets are balanced with each other to form a market for traders and provide access to permanent liquidity.
With deposited funds, trades can now be facilitated in a way that offers a more stable process for buying and selling. The price is automatically determined by the ratio of tokens in the pool and can increase or decrease based on supply and demand.
Importance Of Liquidity Pools
To better understand the need for liquidity in DeFi, let’s look at the order book model that stock exchanges follow. This model allows buyers and sellers looking to either buy low or sell high to place orders.
A trade is successfully conducted when the buyer and seller agree on a final price. Of course, this is not always the case. Factors such as failed negotiations and the absence of liquidity can impact these trades, but they are often fixed by market makers.
The problem with market makers is that relying on them constantly creates unprofessionally slow and often pricey transactions. Liquidity pools fix this issue through automated trading, solving for illiquidity without the need for an order book.
Ultimately, liquidity pools allow you to simply and efficiently exchange assets as a result of the liquidity provided by depositors and the innovation of smart contracts.
However, while they certainly offer many advantages, they are not without risks. Next, we’ll look at a few of the risk factors liquidity providers face.
Liquidity Pool Risks
Impermanent Loss
Since decentralized finance is a new and growing ecosystem, there are still many risks associated with it. One of the common risks is a phenomenon that eliminates lender-provided coins, known as impermanent loss.
When a liquidity provider supplies a pool with assets, they receive a percentage of the pool’s profits. But as the values of each token shift, the lending pool shifts as well. This results in a difference in the ratio of tokens.
Arbitrageurs looking for day-trading opportunities will take advantage of this difference and buy one of the tokens at a discounted rate. Although this balances the lending pool, the changed number of tokens may cause problems for liquidity providers.
Since the provider earns a percentage of the pool rather than a predetermined number of tokens, receiving the funds could mean getting an unbalanced return of the once-equal crypto deposited. In other words, the initial investment could end up becoming a financial loss.
Smart Contract Risks
A defining factor of DeFi is that the financial ecosystem operates without a central authority. Unfortunately, this can also spell trouble for the use of the smart contracts necessary for liquidity pools to function.
This means that should a contract malfunction, assets could permanently disappear with little hope of being insured or recovered.
Slippage
Trading is often influenced by the market’s liquidity. High liquidity equals a stable market, while low liquidity means that fluctuations with value spikes are present.
Slippage occurs as a result of these market types when the price you anticipate differs from the price you actually get.
Slippage can impact all forms of crypto trading and is not even exclusively linked to DeFi. Although it is common across a wide range of other industries, crypto’s inherent volatility can create detrimental slippage.
Tips On Safely Earning In A Liquidity Pool
Liquidity pools have many benefits to outweigh the risks. These include benefiting DeFi platforms by providing liquidity and providing you with passive income.
The key to success is knowing how to mitigate the risks mentioned above to make the most of the benefits. Let’s take a look at some ways you can safely earn with liquidity pools.
Understand Your Tokens
Before you invest in a pair of tokens, you want to verify that they are reliable and capable of helping you build your wealth. Some questions to ask include:
- What are the price trends of the token?
- Does the token have a verifiable whitepaper?
- Who is the source that introduced you to the token?
- Is the source trustworthy?
- Is the token’s current value being impacted by media attention?
- Where does its value come from?
- Where did the token originate?
Doing your research before making a deposit not only sets you up for success but can also save you from an unanticipated financial mess.
Know The Volume And Reserves
You can easily find a profitable pool by checking the pool’s daily volume and size.
The pool’s volume will indicate how much money is available to be made should you deposit assets. Lower volume means fewer trades are happening, which is not ideal for earning profits.
A pool’s size is also important to know so you can avoid rapid price fluctuations. For example, if a pool has low reserves, then tokens become more vulnerable to slippage.
Knowing the volume-to-reserve ratio over time offers a better understanding of the annual percentage yield (APY) rate you can expect. An increasing or stable number is a good sign of a profitable pool. Decreasing numbers indicate that less money is progressively being earned.
Choose The Right Platform
One of the most important ways to offset risk during any crypto endeavor is to thoroughly research the exchange you partner with. Knowing exactly what the exchange provides and how they protect you will ensure you make the most of every opportunity.
Partnering with the best exchange is simple when you know what to look for. An ideal exchange should have:
- Multiple earning options, such as fixed deposits and trading
- Competitive interest rates for earning and borrowing
- An arsenal of security features
- An extensive list of tokens to choose from
- A verifiable list of venture-capital partners
- No hidden or outrageous fees
- Excellent customer service
- Compounded interest and weekly payouts
It’s critical to remember that since DeFi is still new, not every exchange has your best interest in mind. These are a few basic features that ensure you’re partnering with a trustworthy platform that’s proven to help customers safely grow their investments.
At Vauld, we keep your assets safe by moving funds from your wallet to a centralized lending pool that’s insured for $100 million in BitGo, a leading digital asset trust and security company.
Safely Earn With Vauld
Liquidity pools are one of the many lucrative opportunities associated with DeFi. When this strategy is done correctly, providers can earn a passive income while offering a crucial way for transactions to efficiently function.
Knowing the risks associated with liquidity pools is the best way to determine whether the benefits are worth it or if you feel more comfortable investing your crypto in a safe and profitable environment.
For a protected and convenient way to receive some of the greatest benefits in the industry, choose Vauld. Whether you’re lending, borrowing, or trading crypto, we simplify its complexity through automated options and a seamless digital experience.
Sign up with Vauld today and discover the difference that an innovative and customer-centric crypto exchange can make for you.
