The growing popularity of decentralized finance (DeFi) applications has largely been driven by decentralized exchanges (DEXs) and lending/borrowing protocols. Both of these DeFi app varieties rely heavily in their operations on liquidity pools. These liquidity pools offer APR and APY rates that would make any stock market trader fall off the chair. Some are based on established cryptos like Bitcoin and Ether, while others are based on more volatile small-cap cryptocurrencies. The liquidity pools offer unmatched short-term returns to traders and investors who are not shy of a high-risk/high-reward environment.
What Are Crypto Liquidity Pools?
Liquidity pools are crypto asset repositories maintained by some DeFi platforms to meet their operational liquidity needs. Platform users, called liquidity providers (LPs), contribute their funds to the pools in exchange for a share of the fees earned from transactions in the pool.
Liquidity pools help DeFi platforms maintain enough funds to efficiently meet their operational needs. While there are many different types of DeFi apps that use liquidity pools, the two most common ones are DEXs and lending/borrowing apps.
Two Common Types of Liquidity Pools
DEX platforms have been the pioneers of using the liquidity pool concept. Each liquidity pool on such a DEX represents a swap pair, e.g., USDT-ETH. LPs may deposit their USDT and ETH funds into this pool and earn interest every time someone on the DEX performs a swap operation involving these two coins.
For example, the largest and most well-known DEX, Uniswap, charges a fee of 0.3% for each swap operation in the majority of its pools. This fee is then distributed to the LPs of the respective pool proportional to their contribution to the pool funds. For instance, if your share of the overall funds in the pool is 10%, you will get 10% of the 0.3% collected by Uniswap for each swap operation involving the coins in the pool.
The second common type of liquidity pool are lending pools maintained by lending/borrowing apps. These apps allow users to borrow crypto funds, usually with some interest charged on the loan. In order to meet their liquidity needs, they also try to attract funds by offering lending opportunities. You can lend your crypto to these protocols and earn interest on your deposit.
For example, one of the most popular among these protocols, AAVE, maintains a large number of lending liquidity pools, each offering a different expected APY depending on the coin’s popularity with lenders and borrowers, risk levels, and other market-related factors.
On many platforms, when you deposit funds into a liquidity pool, you are issued so-called “LP tokens.” These are synthetic crypto tokens that represent your funds locked in the pool. You may think of these tokens as a kind of “certificate of deposit,” only in digital form.
The great thing about LP tokens is the ability to use them for further liquidity pool lending or staking. For example, if you provide liquidity to a pool on Uniswap, you will get LP tokens that confirm your deposit. You may then take these LP tokens and stake them on a platform where you can earn staking fees. Alternatively, you may re-invest the tokens in a different swap pool.
What Kind of Returns Can You Earn by Investing in a Liquidity Pool?
Annual return rates on many crypto liquidity pools are often several times higher than what you could get from the stock market. The more established providers, such as AAVE and Uniswap, don’t normally have pools with stratospheric APY rates. On some pools with volatile coins, they may offer APYs of up to 20-30%, occasionally more. These APY rates are changing dynamically depending on the on-platform trading activity.
More obscure DeFi providers may offer incredible APYs, often in the hundreds or thousands %, on pools with some new and extremely volatile coins. Although these APY rates look extremely attractive, most investors should probably avoid them. The extreme risks of these pools and providers are simply too high for anyone other than a hardened, high-risk crypto trader.
Even if you stick with the more established providers and their lower APYs, you may still earn handsome returns. Naturally, the risks are also going to be commensurate with your returns potential. In order to benefit from the higher rates, you would need to go for pools with volatile coins. If you invest in pools with established coins, particularly big stablecoins like USDT, USDC, DAI, or BUSD, you are unlikely to earn anything other than abysmal returns, which are often under 1%.
Should You Invest in a Crypto Liquidity Pool?
If crypto investing via the use of liquidity pools interests you, we recommend that you stick with large established decentralized platforms and avoid small players. On the other hand, stablecoin and established coin pools on these DeFi protocols often pay very low APYs. The returns are often so low that you are earning less than if you invested in some low-risk stocks.
The only time when crypto liquidity pool investing might be worth it is when you spot a good rate on a small-cap coin with sound fundamentals. The high risk of investing in the pool might pay off if the coin does well. Naturally, you must be open to investing in a high-risk/high-return way.
We also recommend that before being lured by the promise of eye-watering APYs on DeFi platforms, you spend some time investing minimally to get acquainted with the dynamics of the crypto market and the specific DeFi platform. Each platform has its own rules, pool dynamics, and trading nuances. Thus, test with smaller amounts before jumping in big time. Unlike the stock market, the crypto market is typically friendly to investors with minimal trading amounts.