Feb 18, 2022 · 3 min read · cat
Decentralized exchanges (DEXes) have become the cornerstones of decentralized finance. By creating a viable alternative to centralized trading, they have allowed crypto to decentralize one of the most fundamental facets: trading.
This has created a huge opportunity for the crypto community. Instead of trading fees going straight to a centralized exchange, investors now have the opportunity to take a cut of this money for themselves by providing liquidity to a liquidity pool.
This involves locking an equal valuation of two tokens into a smart contract. Traders can then use this pool to trade, taking out one token in exchange for another. Investing in the pool will lead to returns as liquidity providers take a cut of the trades that occur in that pool.
But how do you know which liquidity pool is best? It can be a complicated proposition. Well, here are a few things you should consider when you’re deciding what liquidity pool to get involved in.
Whenever there’s a trade using a liquidity pool, the AMM will rebalance the price of each token to ensure there’s an equal evaluation of each. This means that when you withdraw your funds from the pool, you always receive an equal of each token. This can lead to something called impermanent loss.
If the price of the tokens moves away from each other after you contribute to the pool, then you will suffer impermanent loss. This is the amount you lose relative to the value of the tokens if you’d kept them out of the pool. What this means, is that you should try to select tokens that have a stable price relative to one another.
The daily volume of trading is a vital consideration for liquidity pools. All of the profit you make will be as a result of trading fees so this will determine how much your return is. Currently, UniSwap, the largest DEX in crypto, charges fees between 0.05% and 1%, with larger fees generally being reserved for smaller cap tokens.
The size of the pool is also a very significant consideration. Smaller pools are far more subject to wild price swings which will leave you vulnerable to impermanent loss. With that in mind, it is best to target more established tokens. However, as previously mentioned, the rewards are generally higher when you go for the smaller caps.
Each investor will have different tolerances for risk and reward and this will determine exactly how small a reserve they should consider.
Yield aggregators are a great way for investors to optimize their yield across multiple different liquidity pools. They will automatically allocate funds across different protocols to ensure that you’re getting good value for your liquidity. Many can be customized based on your own risk tolerances. These are also useful for divesting your funds to ensure that your vulnerability to many of these potential pitfalls is mitigated.
Contributing to liquidity pools is a great way for you to make a return on any tokens, especially you intend to hold for the long term. With many predicting that crypto could be entering a bear market, this could be the perfect time to lock away some funds and wait for the next bull.
Disclaimer: The above article represents the author’s personal views alone and no one else. It is not meant to be taken as financial advice.
About Linear Finance
Linear Finance is a cross-chain compatible, decentralized delta-one asset protocol that allows users to get synthetic exposure to various assets, including cryptocurrency, commodities, and market indices. Users can utilize our cross-chain swap functionality to instantly swap assets across leading blockchain environments and DeFi protocols with unlimited liquidity and zero slippage.