Investing in the liquidity pools of swap applications has become an important trend recently. So much so that crypto investors are closely following swap applications such as Uniswap and Pancakeswap and are almost competing with each other to invest in the liquidity pools of new cryptocurrencies that will be the subject of trading.
So what are liquidity pools and where does their attraction come from? Liquidity pools are created by bringing together a pair of cryptocurrencies of equal monetary value to be exchanged with each other. Let's say we have $1000 and we want to invest in the Ethereum-Bitcoin liquidity pool. We buy Bitcoin with $500 of our money and Ethereum with $500 and add them to the liquidity pool. The related swap application gives us a large portion of the commission income from the trading of the Ethereum-Bitcoin pair as returns. Trading commissions in swap applications range from 25 per thousand to 30 per thousand. Based on this income, the swap application provides liquidity pool investors with annual returns ranging from 10% to 500%. Therefore, those who invest in these pools benefit from both the possible increase in the value of the relevant crypto currency pair and the return of the liquidity pool.
The average return of liquidity pools varies according to the reliability of the platform where the investment will be made, as well as the cryptocurrencies to be invested in. In the selection of the swap applications that I will invest in, criteria such as the total monetary value locked, the number of users, whether the application has passed the security check, whether the application has a unique side, and the speed of implementing innovations. I take it into account. For beginners, it would be a wise choice to choose swap applications such as Uniswap, Pancakeswap, Sushiswap, Mdex, whose crypto money is in the top 100. As can be easily predicted, swap applications with fewer users and locked totals have higher average pool returns.
It is possible to express the risks of investing in the liquidity pool under three headings.
Cryptocurrency price risk: It refers to the decrease in the value of the cryptocurrencies you will invest. Pools of unpopular cryptocurrencies have higher returns, but are equally at risk of dramatically falling in value.
Risk of temporary depreciation: I mentioned that we invest in liquidity pools through a cryptocurrency pair. If one of the cryptocurrencies we invest in has a dramatic decrease in value, this causes the value of the other crypto currency to melt. Although the word 'temporary' is used in the name of the risk, the losses are mostly permanent. You can calculate the risk of temporary depreciation using this calculator: To give two examples; If the value of one of the two cryptocurrencies in the pool remains the same while the value of the other is halved, the temporary loss rate is 5.72%. If the value of one of the two cryptocurrencies in the pool remains the same and the value of the other drops to a quarter, the temporary loss is 20%. These rates represent the extra monetary losses caused by the cryptocurrencies being in the pool.
Smart contract risk: It refers to the risk that the swap application invested in the liquidity pool will be hacked or abused by its employees. Usually, either insiders steal the platform's cryptocurrency and sell it on the market, or there is a flash loan attack. In both cases, the cryptocurrency of the respective platform suffers great losses. In any case, it is beneficial to work with swap applications that have passed the control and obtained security certificates.
Return on investment in liquidity pools is measured by two metrics called APR and APY. Annual Percentage Return (APR) refers to the annualized estimated return on investment. APR is an estimate based on the assumption that the return on the investment in the previous few days will continue for one year. Annual Percentage Yield (APY), on the other hand, expresses the annual return calculated by taking into account the additional income to be obtained by adding the returns obtained during the period to the principal. In APY, the rates are higher because compound interest is involved. I think looking at the daily rate of return instead of these metrics and making a comparison on this daily return will give a healthier result. Assuming an annual return seems a bit of a stretch to me because of the variability of rates of return.
Investing in liquidity pools just with the expectation of high APR or APY is not the right choice in my opinion. Because the price changes of the invested crypto currency pair are more decisive on the return of the investment. My humble advice is to invest in pools containing cryptocurrency pairs that you already find attractive and believe in the potential for return.
It would also be appropriate to consider the current state of the crypto market when investing in liquidity pools. During bull market times, it is possible to invest in pools of relatively high-risk cryptocurrencies. Or, if investments are made in several pools, some of them can be selected from high-yield pools. In bear market times, it would be more appropriate to prefer pools of well-known and reliable crypto currency pairs. In fact, it is possible to make the investment more defensive by choosing one of the crypto currencies such as USDT, USDC, BUSD indexed to the dollar.
Liquidity pools have become very important investment instruments. I am of the opinion that those who can create a suitable portfolio where risks and returns are balanced will have an efficient passive income source that they can benefit from for a long time.