You have to admit the yield rates for being a liquidity provider (LP) looks very attractive. Some DEXs (Decentralized Exchanges) offer like up to 40-50% APY for being a LP. Definitely something every investor in the Crypto market would be somewhat interested in. The first time I went into investing, I was too shocked to see the extremely high returns for being an LP especially if you are putting in both pairs into the pool. The common DEXs are Uniswap, Binance DEX, Pancake Swap and numerous others. Note that some of them are running on the Ethereum blockchain, so their “gas” fees might be pretty high. However I would recommend users to only provider liquidity to DEXs which are more established.
Anyway before you dip your toes into being a liquidity provider, there are some risks you should know about. I am no financial advisor and everything on this article is just for informational and educational purposes. So please do your own research. Anyway back to the risks and there will always be a risk. I would even consider this quite a high risk considering that the Crypto market is volatile. The biggest risk is something called IMPERMANENT LOSS. Basically it is when the prices of the coins or tokens you have added into the pool changes and change drastically.
To simply explain how this works – you add in tokens or coins to the pool and the percentage of your stake is now recorded, lets say 10% of the total amount of tokens in the pool. If one of the token’s value increases, there will be a corresponding decrease in the NUMBER of that tokens in the pool. This is due to arbitrage in which bots come in and start buying up the tokens and hence the number of tokens are reduced. And lets assume that you would now like to withdraw from the pool and as the total amount of tokens in the pool has reduced, your 10% stake will result you in withdrawing LESS tokens than what you have initially put in. And this becomes PERMANENT LOSS. Of course since the LP gets the cut of the trading fees, the loss might not be that great. However if the price of the token rises a lot, you might see a significant drop in the number of tokens you get back especially if compared to just holding on to the token. The opposite is true as well. If the price of the token drops, you will see an increase in the number of tokens you get back when you withdraw. Note the difference between number of tokens and value of tokens. And you are basically hoping that the trading fees (yield) will be more than the loss.
Other than this IMPERMANENT LOSS risk, there is also a risk whereby the DEXs get hacked or exploited and funds get stolen. I believe recently there were a few cases of such hacks occurring. The most famous DEXs that got hacked into recently was DODO. But luckily the amount stolen was relatively small. However this shows that such things do happen. Furthermore DODO is one of the top ten DEXs out there. Kind of disappointing that such attacks still occur for major DEXs. And depending on the DEXs behind it, LPs might find that they might not get back their tokens. And no, the users (as in the traders using the DEXs) usually will not be affected as these DEXs usually work via having their traders transfer tokens in and out of their own wallets. However as the recent Pancake Swap incident shows, even DNS can be hijacked and users (aka traders) can be compromised.
So is it worth the while to become a LP? If you are like me who is not a huge risk taker, I think it is not a good idea to get into providing liquidity to pools. Although many of the DEXs allow you to take out from the pool immediately, there are still plenty of risks involved. There are other passive options out there – lending platforms being one of the them. Or even just staking your tokens. Furthermore the Cryptomarkets are so volatile. Prices of the (non-stable) coins will inevitable rise and dip. You will almost certainly face issues with impermanent loss. But if you are looking to get some major returns without the need for trading, then sure you could look into being a LP. The returns are indeed very attractive. These usually consists primarily of the trading fees levied on the traders. However you do need to know when to withdraw from the pool. For small scale traders like us, the market going up is the time where we should be selling our tokens. However when the price of tokens varied greatly, this is when the impermanent loss is the highest. So please beware if you are looking to become a LP.
Note that in most cases, the liquidity pools would require you to provide an equal value of the pairs for the pools. So for example USDT/DOGE pool, you will need to provide the equal value of USDT and DOGE to the pool for better returns.
You might also be interested in what FOMO & FUD means. Please check out my little rant on how that works and why it could ruin your trading experience.