Liquidity pools are one of the best ways you can earn in DeFi (Decentralized Finance).
They offer both traders & investors an avenue they can both benefit from via providing liquidity & earning rewards from your investment.
In traditional finance, trading usually looks like this:
You have to match a buyer with a seller to a fixed point price (order book model). Both entities must meet at the price both parties are willing to engage before a transaction occurs. That process takes time & often has substantial fees. But with liquidity pools, traders simply use the pool (instead of directly to a buyer or seller) to exchange assets with minimal fees.
Liquidity pools provide both an easier & cheaper avenue for traders while for investors, provide passive income with varying degrees of risk. Liquidity pools are found within DEXs (Decentralized exchanges) like on Osmosis, Polkadot & Uniswap.
Liquidity Pools are possible due to smart contracts & AMMs(Automated Market Maker). These are innovative software codes that allow investors to receive rewards (yields) for providing liquidity to the platform by depositing their funds.
Earning yields
Investors can provide liquidity on a liquidity pool to which they can earn up to 1000% APY(Annual percentage yield) with a bit of an added risk. Liquidity pools are an excellent source of passive income with you literally earning yield on your sleep. As an investment, it caters to all kinds of strategically nuanced pool providers. Conservative pool investors are fond of pools tied to stablecoins because stablecoins are tied to fiat (1 stable token=1USD) thus it offers a stable & steady yield. While for the much daring investor there exists high risk with high rewards pools like the pools which are tied to memecoins.
Whether defense or offense, you can find a liquidity pool for that fix.
How they work
Liquidity pools give you yield from the fees whenever traders use the liquidity pool for an exchange. You earn via the transaction fees whenever someone swaps tokens with the DEX. For example, let’s say you invested into the $ATOM/$OSMO pool over at osmosis.com. You contributed $5,000 (this would be split between the two so $2,500 for each asset) to the pool with a TVL (total value locked) of $10,000.
Let’s say John has a lot of $OSMO on his hands from the yields he saved up, now he wants to exchange these tokens for $ATOM to maybe cash out or take his profits. This establishes his need for the $ATOM/$OSMO pool. Each time a user like John utilizes the pool, you would earn a portion of that fee. Now since you provide liquidity for the half of the pool, you would earn half of the fee once he swaps. Like John, many others also swap. If the total swap for the day is $100, you would earn a $50 yield for the day.
Risks of liquidity pools
All investments come with risk.
- Impermanent loss. It simply means that if one of the tokens suddenly jumps in price while the other stays stagnant, you would not have made as much if you just simply held the token.
- Lockout periods- Pools at osmosis have a lockout period. The longer the lockout period, the higher the APY.
A 14 day lockout period offers the best rates. The downsides to this are when in cases of emergency you will not have instant access to your funds such as when a token drops in price or when a stablecoin gradually depegs such as the case with UST/LUNA. To counter this, investors diversify between different lockout periods.
- Bugs & exploits in the code– These are rare but they occur. Sometimes developers have cracks in their code which are then exploited by some of its users. This is why DYOR(Do your own research) is very important. Invest in projects that you believe are solid.
Key takeaways!
- Liquidity pools provide liquidity to two paired assets that benefit traders & investors
- Liquidity earns you great yields up to 1000% APY w/ an added risk
- Stablecoin pools are a great conservative investment that minimizes risk while giving you great yields
- Impermanence loss means that if one of the two paired with tokens shots up in price relative to the other, you would not have made as much if you simply held
Edmond is a passionate writer for Video games, GameFi and Web3. He has worked for top GameFi companies and video game/crypto news websites.
