Whenever you put your assets to work on the blockchain, it’s crucial to balance risk and reward. Although liquidity pools offer a potentially generational opportunity, users must take a realistic look at the DeFi ecosystem and come up with concrete plans to limit their downside.
Liquidity pools: The cornerstone of DeFi
For decentralized finance (DeFi) to function in a fast and efficient manner, DeFi protocols require liquidity. But how does the liquidity pool process work exactly?
There are several types of protocols for providing liquidity:
- For decentralized exchanges, users provide pairs of crypto assets that allow other users to trade that pair while paying a small fee.
- For lending platforms, users make their liquidity available and earn interest from borrowers who deposit some of their assets as collateral.
- For DeFi insurance, users allocate liquidity to insure the risks of others’ investments. In return, they earn regular fees and possibly some additional rewards.
Let’s now take a closer look at an example where a user provides a pair of tokens as liquidity on Uniswap V3. In return for supplying a pair such as USDC/ETH, the liquidity provider receives an LP token that represents their share in the pool.
Traders who use the DEX to swap tokens pay a fee of 0.05%, 0.30%, or 1%. In addition to selecting a fee tier, liquidity providers on Uniswap V3 can even allocate their liquidity to a specific trading range to capture an even greater amount of fees. Known as concentrated liquidity, this mechanism gives liquidity providers the chance to earn even greater returns — especially if they dedicate a lot of time to conducting research and actively managing their positions.
This is a great example of how DeFi can potentially bring higher returns than traditional investments by leveraging the power of blockchain technology. But while DeFi users directly control their fate, they must also assume the risks and make wise decisions when performing actions like providing liquidity.
Understanding the risks of liquidity pools
Since the crypto market can be quite volatile, it’s important to follow the market cycles. Anticipating a bullish market, investors can make significant profits from carefully selected non-stable assets. On the other hand, it could be advantageous to allocate more capital to stablecoins when token prices appear to be at their peak.
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Stablecoins can be tied to the value of less volatile assets and allow users to earn some returns while limiting their risk. On a stable-swap DEX, investors can provide liquidity on pairs of multiple stablecoins to earn yields with minimal impermanent loss.
Impermanent loss is one of the most notorious risk factors in the DeFi space. When providing a pair of tokens as liquidity, the value of the crypto assets can move in opposite directions — sometimes violently. Once the user wants to break up their pair to recover their initial investment, it is possible that the value of the sum of the two tokens is lower than if they had staked them or even just held the tokens separately.
This is called impermanent loss because the change is only realized when the investor withdraws their liquidity. With this in mind, users should always be careful and compare their potential losses to the returns offered on the pool.
Overcoming the challenges
First of all, tokenomics are always fundamental. Is the supply limited, deflationary or inflationary? Are there burn mechanisms? What is the share of venture capitalists who are invested? What is the team’s level of expertise and commitment, and what is their token vesting schedule? What is the token utility, and do people use it, keep it or dump it? Continue this investigation on GitHub and make sure to read the project’s audit reports.
The first step before investing in DeFi is to research the protocols and understand them. If you have a large amount of capital, it is hugely beneficial to first invest your time in learning from others who have more experience.
Furthermore, diversifying your assets, stablecoins and protocols is important risk protection, and subscribing to DeFi insurance can also be a smart decision. Insurance protocols can protect you against risks like a stablecoin depeg, insolvency event, liquidity pair imbalance or the hack of a smart contract. While you should be aware of the scope of your coverage, insurance is often the only way to recover your funds in case of an accident. Allocating capital to different platforms, blockchains and ecosystems also allows you to protect yourself against hacks, exploits or protocol bankruptcies.
Diversifying your strategies is also crucial. Consider avoiding going all in on entering liquidity pools, and consider allocating some funds to relatively more conservative strategies like staking. While the rewards might be smaller, staking can mitigate risks while also helping protect the underlying security of proof-of-stake blockchains. Although you might miss out on some passive income, it also helps to keep some of your capital in cold storage to guarantee that you always have a reserve fund on standby.
Knowledge is power
Making the most of liquidity pools requires rigorous research and careful planning. With a well-executed strategy, it’s possible to generate generous returns. But while making gains is always the goal, investors should also be realistic about potential risks. Useful ways to protect your downside are taking the time to discover the best opportunities, surrounding yourself with well-informed people and diversifying your DeFi investments. While all of these processes take time, your growing knowledge base will pay dividends in the long run.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Wolfgang Rückerl is the CEO of Istari Vision and Entity.global. His expertise is in Web3 startups, DeFi and GameFi.
This article was published through Cointelegraph Innovation Circle, a vetted organization of senior executives and experts in the blockchain technology industry who are building the future through the power of connections, collaboration and thought leadership. Opinions expressed do not necessarily reflect those of Cointelegraph.