Understanding Liquidity Pools: Rewards and Risks Involved (2024)

Over the past year or so, liquidity pools have become a popular way of earning rewards in the DeFi space, attracting an increasing number of users. In this article, we’ll discuss how liquidity pools work, what earning opportunities they present and what possible risks should be taken into account.

What is liquidity?

Basically, the term ‘liquidity’ in crypto indicates how easy it is to swap one asset for another or convert a crypto asset into fiat money. Liquidity is a crucial factor for all operations in DeFi, such as token swaps, lending or borrowing.

Low liquidity levels for a specific token lead to volatility, prompting severe fluctuations in that crypto’s swap rates. Conversely, high liquidity means that heavy price swings for a token are less likely.

What is a liquidity pool?

Liquidity pools occupy a large and important space in the DeFi ecosystem. A liquidity pool is basically a reserve of a cryptocurrency locked in a smart contract and used for crypto exchanges. Each liquidity pool consists of two tokens, that’s why liquidity pools are also referred to as pairs.

One of the liquidity pools’ most popular uses are decentralized exchanges operating on the automated market maker (AMM) model. As opposed to traditional, order-book exchanges, on AMM-based DEXes, users trade crypto with smart contracts rather than with each other, and rates are based on mathematical formulas.

Say, a user wants to swap token A for token B on an AMM-based DEX. So, the user goes to the DEX's A-B liquidity pool, deposits the amount of A they want to swap and receives in exchange an amount of B determined by the smart contract.

But, for users to be able to swap any amount of A or B at any time, the pool has to have sufficient amounts of A and B tokens – or, in other words, to have deep liquidity for both of the pool’s tokens. Therefore, every DEX operating on the AMM model is interested in having the deepest possible liquidity.

Earning on liquidity pools

To achieve deep liquidity, AMMs need to incentivize users to deposit their tokens to pools. Here, the concept of yield farming (also known as liquidity mining) comes into play.

The general idea of yield farming is that users earn token rewards in exchange for providing liquidity to AMMs’ pools to facilitate token swaps. This is similar to depositing fiat money to a savings account in a bank and collecting interest on the deposited assets.

Users who deposit their crypto to pools are called liquidity providers (LP), and rewards paid to them are referred to as LP fees or LP rewards. LPs have to deposit an equal amount of both of the pool's tokens.

LP rewards come from swaps that occur in the pool and are distributed among the LPs in proportion to their shares of the pool’s total liquidity.

In addition, projects interested in promoting their coins sometimes give away their tokens to providers of liquidity to specific pools. Those extra tokens, added on top of the standard LP awards, could substantially increase a liquidity provider’s total yearly rewards.

A user's yield from providing tokens to a liquidity pool varies significantly, depending on the protocol, the specific pool, the deposited coins and overall market conditions. Some pools boast high rates of rewards, but they can also have more volatility and present more risk.

Risks involved in liquidity pools

The most common risk that liquidity providers could face is that of impermanent loss. In simple terms, impermanent loss means that the fiat value of a user’s crypto assets deposited to a pool could decline over time.

Impermanent loss is inherently interwoven in the AMM concept and occurs when the price of a pool’s tokens changes compared to when they were deposited. The more significant the change is, the bigger the loss. Sometimes, impermanent loss could be negligible, but sometimes it could be huge.

Since impermanent loss happens because of volatility in a trading pair, pools featuring at least one stable asset (an asset whose value is pegged to a fiat currency, most commonly to the USD, such as Dai, USDC or USDT) are less vulnerable to impermanent loss. Similarly, for pairs of two stablecoins, the risk of impermanent loss is the lowest. In fact, depending on the pool, rewards to liquidity providers can even offset impermanent loss over time.

Another thing that liquidity providers should keep in mind is smart contract risks. Once assets have been added to a liquidity pool, they are controlled exclusively by a smart contract, with no central authority or custodian. So, if a bug or some kind of vulnerability occurs, the coins could be lost for good.

In addition, users need to be wary of projects in which pool governance is done by the developers, with no control transferred to the community. In such cases, there is a possibility for malicious actions on the part of the developers, such as taking control of a pool’s assets.

Time to dive in

Liquidity pools are a backbone of the AMM segment and an essential earning tool for DeFi users. In addition to AMMs, liquidity pools facilitate other segments of DeFi, such as, for instance, decentralized lending and borrowing. Still, participation in liquidity pools involves risks, which users have to keep in mind before making any decisions.

Liquid swaps with MEW and 1inch

MEW works with 1inch to provide the best swap rates and to alert the user when a swap may not be backed by sufficient liquidity. This helps MEW users avoid issues with swaps and ensures that they get not just the best rates, but the best experience. Download MEW wallet app to start swapping ETH and tokens right from your phone, or connect to MEW web with your hardware or mobile wallet. Be the first to hear about new earning and liquidity providing opportunities in MEW by signing up for our newsletter and following us on Twitter!