DeFi offers some amazing return if you put your crypto to work. On some decentralized exchanges you can see APYs of over 100% an sometimes even up to 500%. One of the way to utilize these DEXs is by using a Liquidity Pool. In this article I want to talk about Liquidity Pools, how they general work, what some risks it might involve and what my experience with these Liquidity Pools are.
How Do Liquidity Pools Work?
In general, Liquidity Pools (LP) allow users to trade certain coin pairs on decentralized exchanges. For each coin pair that people can swap there is a LP and people can select the coin pairs that they want to swap. These LPs can be found on sites like Uniswap or Pancakeswap. There, you can find pairs like BNB and CAKE. For simplicity reasons we will stick with the coin pair BNB-CAKE on the Binance Smart Chain but you could also use Ethereum and USDT as an example. So, if a user wants to swap his BNB into CAKE or vice versa, he just goes on one of these decentralized exchanges and swaps the amount he wants to swap. To do this he also needs to pay a small fee to make this transaction happen. This fee is given to the person who provides this LP.
So how can people like you and me make money with this? It is possible for us to provide the liquidity for these pools and earn the fee that people are using to swap the tokens! In order to provide liquidity to a pool it is necessary to provide the same worth amount of coins. That means that if you have a thousand dollars worth of BNB and zero dollars worth of CAKE, it wont work. To provide liquidity you have to have 500$ worth of BNB and 500$ worth of CAKE. After you provided the Coins to the pool, you get an LP Token. This is basically your receipt that you provided a certain amount of a token pair. Now, usually you would be able to get a certain percentage of the LP’s fees as reward because you are providing the liquidity. Additionally, you can now stake the LP Token in a farm and earn additional rewards.
Impermanent Loss And Rug Pulls
This sounds pretty amazing and can be utilized to make some great return. So where is the problem with this method and why is not everybody using it? Well with great rewards, comes great risk as Uncle Ben said to Spiderman once. There are a few risks that have to be kept in mind when using those tools. First, there is the overall risk of volatility of crypto. If you put in 1000$ in total into such a LP and the market crashes then you would lose some of your funds. But this would happen even if you would have just hold the coins.
The real risk comes with impermanent loss. In general, this happens when a price of one token changes drastically to the other token in the token pair LP. Without going into to much detail, the following graph explains impermanent loss very good. If the price of one token starts to rise the total liquidity value of your pool falls and if the price drops the value of your pool falls as well. That means that if one token would start going to the moon, you would have been better of just holding this token rather than providing it to the liquidity pool.
The other risk involved with such LPs, are rug pulls. In general, rug pulls can happen everywhere in the crypto space but if a coin goes to zero in a liquidity pool this would mean that you would lose automatically the other half of your legit coin as well. This is because your legit coin would be trading against the scam coin and if somebody has the decision between a coin that is worth zero or a legit coin he would rather choose the legit coin and so he would trade it trough your LP. That means that if you are not sure whether a coin is legit or not, do not provide liquidity towards it as it would harm you and the community. Of course, it is not always easy to recognize a scam but sometimes there are already some reddit posts or some other indicators that would suggest so.
Everybody who wants a more detailed explanation of the risks and how this whole process works in general, I recommend watching following video, as it describes things very accurate and easily:
My Own Experience And Conclusion
I also tried the experience of a LP. I provided some of my funds in BNB and CAKE. That is why I chose this Token pair as example in this article. In the beginning I saw some really nice rewards and payouts. I was paid in CAKE and this CAKE I could then also stake on Pancakeswap which gave me additional rewards. After some time, I noticed that the BNB coin kept gaining in value, while the CAKE Token stayed or even lost in its value. This was the first time I experienced a minor Impermanent Loss. As this was just a experiment I also tried some other LPs with higher APYs. But after some time I started feeling anxious about some of these coins because they did not seem legit to me. One example was the Duelist King Coin (DKT). With this experience in mind I closed all my positions and turned everything into BTC as it is a more “safe” investment in the crypto space.
I know that it was maybe unwise of me to not take some risk but I really did not like the idea of losing money to a scam coin. With this being said, the BNB-CAKE Pool is a legit Pool and it offers around 40% APY so in the future I will think about reopening my position in this sector. All in all, I must say that for me it was maybe a bit too early but definitely worth an experience. It is very interesting to see how the DeFi space is developing and I can totally see myself going back to this method!
Published by ga38jem on
LeoFinance|Steemit|read.cash
On 29th November 2021
Sources:
https://finematics.com/impermanent-loss-explained/
https://www.gemini.com/cryptopedia/what-is-a-liquidity-pool-crypto-market-liquidity
I am in the same LP pool with bnb and cake, but cake has been steadily falling in price compared to Bnb...