Investing in Liquidity Pools: What to Know

Image credit: SwyftX Learn

What are Liquidity Pools?

Coin Desk loosely describes liquidity pools as a digital pile of cryptocurrency that is locked into a smart contract on a decentralized exchange. Liquidity is provided by anonymous individuals — DeFi users — with the promise of earnings. The DEx (decentralized exchange) earns money from trades between the two tokens and passes a percentage of the fees earned from the trade onto liquidity providers. Usually, liquidity pools are comprised of two tokens. However, there are often single token vaults on DeFi exchanges (often used to lock up governance tokens on a protocol) and there are also pools that consist of three tokens (e.g. the famous Tri-Pool on Curve Finance). In the case of the Tri-Pool on Curve Finance, liquidity providers earn profits from the trades between the three top stable coins on Ethereum (USDT, USDC and DAI).

Image credit: Curve Finance

Volatile Pairs:

A volatile pair is a pair of cryptocurrency assets that are subject to drastic changes in price action. They have high exposure to the trademark volatility of the cryptocurrency market. Usually, especially on emerging DEXs, you will find a common volatile pair consisting of the blockchain’s native asset (e.g. ADA on Cardano) and the DEx governance token (e.g. Min on MinSwap). As an example in the image below, you can see an image of the ADA-Min pair on MinSwap, a decentralized exchange on the Cardano network. Both of these assets are volatile, so the price of these tokens could move up or down dependent on market forces. With this volatility comes risk. You may lose or gain money depending on the money that has flowed into the market. What may go in the favor of this pair, is that both the ADA and MIN tokens are likely to move in the same direction. Where they move in opposite directions, you may be exposed to a phenomenon known as impermanent loss.

Image credit: MinSwap

Stable pairs:

A stable pair is usually comprised of two stable coin assets. In the aforementioned tri-crypto pool on Curve, this is a three-asset pool of stable assets. More commonly, as depicted in the image below, you can see two of these assets in a stable liquidity pool on Thena Finance, a DEx on the Binance Smart Chain. It is more common for assets to be paired in this fashion than a tri-pool. You might notice that the suggested APR returns are much lower on stable pairs. This comes from their lack of price volatility and the low risk level of investing in them. These assets — USDT and USDC — are assets that are pegged to the USD.

Image credit: Thena Finance

Volatile-Stable Pairs:

Volatile-Stable pairs are liquidity pools that consist of one volatile asset and one stable asset. Usually, these will consist of a native asset such as SOL on the Solana blockchain and a stable coin such as USDC. The existence of such a pair may seem counter intuitive due to the juxtaposition of stable and volatile price action. The benefit of these pools is that trade volume is often high between these two assets on a DEx. Stable coins are popular assets to acquire due to their price-peg to the United States dollar and as a means to store gains made from trading volatile assets at peak trading times in the bull run. The image below shows the trading volume in a 24 hour period on Raydium.

Image credit: Raydium

Providing Liquidity and Liquidity Pool Tokens:

In the case of Orca, a decentralized exchange on Solana, liquidity pool tokens are stored in the form of an NFT. In other cases, you deposit these tokens into a pool to activate the smart contract. Be aware of how the receipt of your liquidity is stored in your wallet. In my case, I am currently invested in the SOL-USDC pool on Orca. If I were to burn this NFT or move it from my wallet, I would lose access to this liquidity.

Things to consider:

• Balancing the volatility of the pools that you invest in: you may wish to start yield farming by trading in volatile and volatile-stable pairs at first, dependent on your risk tolerance. Then, profits can be reinvested into stable-pairs or single asset vaults on protocols like Stargate Finance (Ethereum and EVM chains only);
• The volume of trading on a DEx: pay attention to the frequency of trade-pairs on the DEx that you are interested in. Do not fall prey to the promise of high APRs/APYs on pools that have no liquidity;
• Look for pools that contain high amounts of liquidity: ideally, invest in pools that contain a large value of liquidity. Look for valuations of a million dollars or above unless you really have faith in the projects behind the tokens in the pool;
• Avoid small-cap market pairs: avoid investing in projects that have a small market cap unless you have faith that the tokens in the pair will grow exponentially in the future;
• Exposure to impermanent loss: when you provide liquidity to a liquidity pool, you are investing in the protocol’s liquidity in exchange for a receipt of the liquidity that you provided. This liquidity earns rewards from DEx fees. This is a complex process and be aware that in the short term, simply holding a single asset may be more lucrative than pairing it against another asset, especially in the short term;
• Smart contract risk: The codes that are used to lock funds into protocols are vulnerable to a certain amount of risks. Be aware of these and only provide an amount of liquidity that you are willing to risk losing. While not as risky as leveraged trading, the downside of DeFi is that there are no safeguards in place to protect your funds;
• Interacting with decentralized exchanges: download a reliable web wallet to interact with DExs. Note that some wallets are blockchain or virtual machine specific. Some wallets to consider: Metamask (Ethereum and EVM Chains); Keplr (Cosmos Ecosystem); Nami (Cardano Ecosystem); and, Phantom (Solana Ecosystem).

Advice moving forward:

In four words: “Diversify everything. Stay agnostic.” Start by investing in volatile assets on secure blockchains. When the market rises during a bull-run, take profits and diversify into stable assets. Follow the money and do not become tribal about a certain project. Be aware that any liquidity your provide is capital that is at risk. Be aware of smart contract risks and always do your own research. DeFi is very new and the space is always changing. Remain informed, stay dynamic in your decision-making and pay attention to the total value locked into a protocol. If anything feels fishy or outside of your risk tolerance, then reclaim your funds.

Disclaimer: this is NOT financial advice. I’m a cow and I like to eat cereal. Any knowledge gained from this post is merely incidental and you are responsible for your own financial decisions. Make investments wisely and make sure to do your own research.