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The risks and rewards of providing liquidity.

Updated: Oct 28, 2022

Here is what you need to know before pooling your tokens in an automated market maker.

Chances are, you first purchased cryptocurrency on an exchange like Coinbase or Binance. These corporations are best at converting fiat into a blockchain-based asset, but they are under high regulatory scrutiny, offer sub-market exchange rates and profit from charging their users with high fees.

Decentralized exchanges have emerged as an alternative to the growing number of traditional cryptocurrency trading companies. Also known as DEXs, decentralized exchanges are automated market makers, a protocol that uses smart contracts to exchange two or more cryptocurrencies on the blockchain without an intermediary or central authority.

For each transaction on a DEX, a fraction of a percent is usually deducted as a participation incentive for liquidity providers. This small fee is distributed proportionally among all the liquidity providers to reward them for locking their cryptocurrency so that users can freely swap tokens.

By providing an equal amount of two different tokens to a liquidity pool (LP), you can earn a proportional share of the fee paid each time a user exchanges crypto using that pool. Some liquidity protocols even offer an annual percentage yield as high as 150% or more on deposits. So, what's the catch?

It is impermanent loss, the Achilles heel of automated market maker protocols. Impermanent loss is a symptom of volatility that occurs when the value of one asset in a liquidity pool increases or decreases compared to other assets in the pool. If a liquidity provider withdraws a balance that has an impermanent loss, this can cause it to become a permanent loss.

How impermanent loss works

Say a liquidity provider deposits into an ETH-USDT pool at $4,000 per ETH. Since USDT is pegged to the dollar, they provide 1 ETH and 4000 USDT to the pool, a total balance value of $8000. Most liquidity pools contain an equal ratio of each token, which in this case is 50:50 between ETH and USDT.

Once deposited, the price of ETH is frozen at the time of deposit. This means that if, for example, the price of ETH goes up to $6000, the pool adjusts the provided liquidity to maintain a 50:50 ratio, causing the balance to equal 0.8165 ETH and 4899 USDT due to impermanent loss. The total value of this balance would be $9797.96, resulting in an impermanent loss of $202.04.*

In this example, $202.04 is the amount the liquidity provider lost by depositing into the pool as opposed to holding their crypto instead. If ETH went back down to the deposit price of $4000, the impermanent loss would reverse itself and the balance would return to its original value. However, if the liquidity provider withdraws when ETHs price is significantly higher than at the time of deposit, any value lost is permanent.

Ways to reduce risk

It's not necessary to know how to calculate impermanent loss or even understand how it works in order to avoid it when liquidity pool farming. One simple way to evade impermanent loss is to pool pairs of stable coins, or cryptocurrencies pegged to a set price. For instance, if USDT and USDC are cryptocurrencies that will always equal $1 they would be an excellent low-risk liquidity pair.

Stablecoins are exceptionally low risk because their stability protects you from impermanent loss, but research is crucial for making proper risk evaluations. Just like every cryptocurrency, not all stablecoins are equal — some are backed by a tangible asset like gold or a fiat currency while others are "soft pegged" with nothing securing a stable value. It's important to understand the differences between stable coins because impermanent loss can still impact stable coin liquidity pairs even if they are relatively less risky compared to other asset pairs.

The best way to avoid succumbing to impermanent loss is by not withdrawing. Some protocols award liquidity providers with liquidity pool tokens which can be staked for additional rewards. These LP tokens represent a share of a liquidity pool and, if staked, offer an annual percentage yield that may mitigate the impact of impermanent loss. Ultimately, because liquidity providers earn fees just by staying in the pool, it's better to keep withdrawal as the last resort.

Choosing reputable projects is important due to the prevalence of fraud in crypto. Rugpull schemes occur when developers shut down a project and disappear with investors' money. It is common for developers in decentralized finance (DeFi) to maintain their anonymity and not register with financial authorities, but this means that investors must be extremely cautious not to support projects that may vanish without a trace. Taking time to conduct research is key to not getting scammed.

Is liquidity pool farming even worth it?

Whether or not you should begin liquidity pool farming depends on the size of your portfolio, your risk tolerance and your short- and long-term investing goals. Which blockchain network you use might also be a factor to consider. Currently, it is not advised to use the Ethereum network due to high transaction costs known as gas. Rather than paying hundreds of dollars in fees to process each transaction, other networks that charge a fraction of a cent per transaction are a better option for smaller investors and those new to DeFi.

Networks with lower transaction costs are more accessible for DeFi applications, but they are also optimal environments for unscrupulous acts. Arbitrage traders take advantage of low network fees and differences in exchange rates between DEX's to make profitable trades at the expense of LP providers. Worse more, your favorite DEXs or DeFi platforms could be duplicated into identical copies used to phish your sensitive wallet information like private keys and seed phrases, so it's important to bookmark the proper URL and make sure you are always using a trusted platform.

Liquidity pool farming is a great opportunity to profit from multiple assets that would otherwise sit idle at the cost of further exposing your portfolio to the impacts of market volatility. While LP farming has inherent risks, investors must be aware of all the other hazards of operating in DeFi. It never hurts to do your own research into automated market makers before locking your assets into a liquidity pool.

* (This does not factor in accrued liquidity provider rewards).

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