Related: DeFi lending and borrowing, explained
What are the risks of DeFi liquidity pools?
The algorithm that determines the price of an asset may fail, slippage due to large orders, smart contract failure and more.
The price of assets in a liquidity pool is set by a pricing algorithm that continually adjusts based on the pool’s trading activity. If an asset’s price varies from the global market price, arbitrage traders that take advantage of price differences across platforms will move to profit from the variance.
In the event of price fluctuations, liquidity providers can incur a loss in the value of their deposits, known as impermanent loss. However, once a provider withdraws their deposit, the loss becomes permanent. Depending on the size of the fluctuation and the length of time the liquidity provider has staked their deposit, it may be possible to offset some or all of this loss with transaction fee rewards.
Due to the pricing algorithm, smaller pools can suffer from slippage if someone suddenly wants to place a large trade. There have been instances, such as the bZx hack in 2020, where users exploited smaller liquidity pools as part of a broader market manipulation attack.
DeFi users face other risks, such as smart contract failure, if the underlying code isn’t audited or fully secure. Make sure to understand all the risks before depositing any funds.
What are the benefits of DeFi liquidity pools?
The most obvious benefit of liquidity pools is that they ensure a near-continuous supply of liquidity for traders wanting to use decentralized exchanges. They also offer the opportunity to profit from cryptocurrency holdings by becoming a liquidity provider and earning transaction fees.
Furthermore, many projects and protocols will offer additional incentives to liquidity providers to ensure that their token pools remain large, reducing the risk of slippage and creating a better trading experience. Therefore, there’s an opportunity to generate further gains from yield farming reward tokens in return for becoming a liquidity provider.
Some protocols, including Uniswap, Balancer and Yearn.finance reward liquidity providers in their own platform tokens. When SushiSwap emerged in summer 2020, it used this model to launch a so-called “vampire attack” on Uniswap. Users could yield farm the SUSHI token on Uniswap by providing liquidity in advance of SushiSwap’s launch and later migrate the liquidity to the SushiSwap platform, which was also a fork of Uniswap’s code.
How can I join DeFi liquidity pools?
The exact procedure for joining DeFi liquidity pools varies according to the platform. In general, one would need to set up an account on the platform of choice and then connect an Ethereum wallet such as METAMASK or other Web 3.0 wallets from the homepage. After that, tokens can be deposited into the relevant liquidity pool.
On platforms, such as Uniswap, one would need to search for a specific pair they want to provide liquidity to and then connect the wallet. After checking the returns, such as the pool ratio and the exchange rate, a user can deposit the tokens into the pool.
