My latest video contains a quick no fuss analysis on liquidity pools, how they work, the risks involved and also the pools which I think are the best to invest in. The information within this video should not be considered financial advice, all opinions are that of my own and if you intend on investing your own capital, you should always seek professional advice or do your own research.
Liquidity refers to the ease of which an asset can be sold quickly for another. It is essential to DeFi (or decentralized finance ecosystems) given that there are no centralized authorities providing the liquidity for users (such as on Binance, Coinbase and other popular exchanges).
The problem is that centralized exchange will always tend to situate the advantage within their favor when exchanging tokens because they have a monopoly on the exchange of those tokens because you're interacting with their order book.
They make money on the “spread” in between the purchase and selling rates of those tokens.
It's a catch 22 because without these centralized authorities or market makers, the exchange market loses its liquidity and becomes inconvenient for the average user due to higher spreads and the longer duration taken to swap tokens.
This is where liquidity pools shine. The idea behind liquidity pools is pretty simple. These pools allow us to forego the order books of market makers and centralized services by re-distributing all of the fee's and trading activity income among the pool participants and liquidity providers.
On Tribal DEX or HIVE engine for instance, there’s a fixed transaction fee of 0.25%. In a nutshell, liquidity providers get to earn a portion of the pool’s trading fees according to what share of the pool they own as reward for their services. Over time, Liquidity providers can earn substantial amounts annually through trading in liquidity pools if the conditions are favorable. You'll also see that some liquidity providers switch between numerous liquidity pools to boost their earnings based on APR's which is known as yield farming.
Although these APR's may look extremely enticing, there are some associated risks which you will need to consider before becoming a liquidity provider. The most important being impermanent loss.
Impermanent loss refers to the temporary loss of liquidity pool tokens. This happens due to a number of factors, but mostly in the form of price volatility. For instance, in the case of a SPS and DEC liquidity pool, if the price of SPS drops by 20%, then Liquidity providers get less value back. This is because they’ve lost 20% on their initial deposited amount into that pool. Therefore, these tokens are no longer equal to their initial value when deposited into the pool, resulting in a transient loss.
In volatile or bear markets, liquidity pools can be thwart with danger for novice investors because frequently there can be these type of swings that can result in impermanent loss.
Moreover, based on the size of these price swings and the duration which a liquidity provider stakes their deposit, the impermanent loss might be offset partially or fully with the rewards, but if you are a liquidity provider and you choose to withdraw your deposited funds before this happens, you will need to be aware that your loss has now become permanent.
When choosing the right liquidity pool for your investment, it's similarly important to recognize that token pairs with higher liquidity have higher trading volume and lower volatility, whereas those with less liquidity have higher volatility. Understanding this concept will ultimately lower the risk entailed. Of course there is the flipside to this in that pools with larger reserves are less profitable from fee's as there is plenty of liquidity to fill larger orders. So you will need to decide which approach is suited depending on your appetite for risk.
The ideal scenario for liquidity pool holders is “sideways” trading with no large swings to the downside or the upside. This will allow you to earn your portion of rewards whilst still maintaining your original deposited position. It is for this fact that correlation analysis is vital to finding pairs which share similar price attributes.
It is important to do this type of analysis frequently as token pairs can decouple quite regularly. For this reason, if you do not have the market knowledge it may be best to stick to regular staking rewards and leave the liquidity pools to the whales.
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