Liquidity Pooling

liquidity pooling

[DeFi basics] [Lending] [Staking] [Liquidity Pooling] [DeFi risk levels]

Liquidity pooling (also called liquidity mining) offers the highest returns in the DeFi industry.

To understand how it works, you first have to understand how a decentralized exchange works.

How a decentralized exchange (DEX) works

  • A DEX does not deal with fiat currency (such as US dollars). It only deals with the exchanging (swapping) of one cryptocurrency for another.
  • Anyone who wants to swap tokens on a DEX needs to do it through a liquidity pool.
  • A liquidity pool consists of two tokens where one can be swapped for the other.
  • For example, if you want to swap ETH for USDC or vice versa, you do it though the ETH-USDC liquidity pool. If you want to swap DAI for LINK or vice versa, you do it through the DAI-LINK pool.
  • A DEX is made up of multiple liquidity pools, each consisting different pairs of tokens. Through these pools, anyone can swap one token for the other, for a small fee.
  • On the other hand, anyone can deposit their tokens into a liquidity pool to earn these fees. This is called 'providing liquidity'.

These are the basics of how a DEX works. If you want to learn more about liquidity pools, check out this video.

Now, you're ready to learn about liquidity pooling.

How Liquidity Pooling works

In liquidity pooling, you deposit two different tokens into a liquidity pool (LP).

Then, you'll start earning a portion of the fees the LP charges to people who swap tokens through it.

Here's how it works:

  • You deposit Token X and Token Y into the LP. The dollar value of both deposited tokens must be the same.
    Example: You can deposit $100 of Token X and $100 of Token Y. You cannot deposit $100 of Token X and $90 of Token Y.
  • After depositing both tokens, you'll receive some amount of 'LP tokens' that prove you own a percentage the assets in the LP.
    Let's say the combined dollar value of your two tokens make up 0.05% of the LP.
  • When someone uses the LP and swaps Token X for Token Y, they "pay fees" by receiving slightly fewer tokens of Token Y.
    Example: The price of 1 Token X = 1 Token Y. Anyone who swaps 1 Token X in the LP may only receive 0.98 Token Y. The difference of 0.02 Token Y is the fee he pays, and it is added to the LP.
  • As more people use the LP, the size of the LP grows from the charged fees.
  • When you wish to withdraw your tokens, you return the LP tokens and receive the appropriate amount of both tokens proportionate to the size of the LP.
    Since you own 0.05% of the LP, as the size of the LP grows (from the charged fees), the number of tokens you'll withdraw grows as well. This is how you earn tokens in liquidity pooling.

Liquidity pooling yields

Liquidity pooling yields vary widely. I've seen yields as low as 2%, and as high as 1,000%.

The rule of thumb applies: The more risk you take, the higher your potential return.

So be warned: If you don't know what you're doing, chasing extremely high returns can get you burned.

Why are liquidity pooling yields so high?

A few reasons:

  • Liquidity pooling is generally of higher risk, so the returns have to be high enough to compensate for it.
  • DEXs want to incentivize liquidity providers to stay on their platform, and are willing to offer higher returns to gain market share.
  • Liquidity pooling is a relatively new phenonmenon, so the market pricing of risk is not (yet) efficient. Over time, the returns will go down.

One more thing: the yield depends on the type of tokens you're depositing into the pool. For example, if you're providing liquidity to a dual-stablecoin pool, the returns will be lower and more stable than if you were providing liquidity to an dual-altcoin pool.

To be an effective liquidity provider, you have to understand the source of the risks and returns. The better you understand where they come from, the better your results will be.

Liquidity pooling risks

These are the main risks to consider when liquidity pooling:

Smart contract risk

Everything in DeFi runs on smart contracts (i.e. software). If these smart contracts are not programmed properly, things can go wrong and you may end up losing your tokens.

Remember: there are no technical standards in DeFi, so smart contract failures are quite common. Here's an ever-growing list of blowup examples.

The best way to reduce smart contract risk is to never join new, unproven initiatives. I personally only join platforms that are at least 6 months old and have more than $500 million in total value locked (TVL).

Counterparty risk

Counterparty risk is applicable to all financial markets, including the traditional ones.

It is especially important in DeFi however, because the industry is completely unregulated.

A DEX can shut down at any time, and there would be nothing that you, or anyone else can do about it.

To minimize counterparty risk, I only transact with the largest, most established exchanges and platforms.

Impermanent loss risk

When providing liquidity in any liquidity pool, you are at risk of impermanent loss.

Impermanent loss is a new concept, so be sure to educate yourself on how it works before participating in liquidity pooling.

Price risk

Cryptocurrency prices are notoriously volatile.

Keep this in mind when evaluating liquidity pools. An APR of 200% may not be a good idea if the price of the token drops 15% in a week.

Always weigh the estimated APR against the price volatility of the tokens involved.

Now... with so many different ways to earn a yield in DeFi, which approach should you pick?

A good way to answer this question would be to first understand the risk level of each activity.

Next: DeFi risk levels