What are liquidity pools in DeFi and how to make money on them

Decentralized finance (DeFi) allows the user to maintain complete anonymity in the cryptocurrency market. One of the ways to generate passive income on DeFi are liquidity pools. It was the emergence of liquidity pools that made decentralized cryptocurrency exchanges as popular as centralized ones.

How Liquidity pools work

The liquidity pool can be considered as an asset repository that unites the funds of many owners of crypto assets. Funds from the pool are used for conducting transactions. All processes are automated, which completely eliminates errors due to the influence of the human factor.

The method of passive earnings on liquidity pools is called farming. The rules of farming are spelled out in the smart contracts of the decentralized platform. Now farming is a popular form of income generation that does not require the cost of powerful equipment and electricity.

Users who have placed assets in the liquidity pool receive remuneration for this in the form of a percentage of the deposited funds. Thus, liquidity pools can be considered as an analogue of bank deposits. As a rule, their percentage is higher (from 10% to 100%), but the risks are also increased.

How to make money on pools

Those who want to make money on farming, first need to get a cryptocurrency wallet, if the user does not have it yet. One of the most popular crypto wallets is MetaMask. You can also use other wallets supported by a specific platform.

When the wallet is configured, you can deposit assets into the liquidity pool on the selected decentralized cryptocurrency exchange. For example, the Uniswap crypto exchange is popular on the basis of Ethereum.

After entering the exchange, you need to click the Connect wallet button to link your wallet. Linking a wallet replaces the registration process. And there can be no verification process (identity verification) or verification of the legality of the assets used on DeFi in principle. To get started, you need to buy tokens if you don’t have them in your wallet.

After that, you can connect to the pool using a wallet.

Liquidity pool risks

In addition to the advantages, the storage of assets on decentralized platforms also has disadvantages. They are partly related to the security of using define.

Hacking of decentralized exchanges is the most dangerous for asset owners. Thus, the Cream Finance crypto exchange was subjected to hacker attacks several times, after which users partially lost funds and there was a sharp decrease in the value of the exchange’s internal token.

The users themselves may be to blame for the loss of funds. It is important to safely save the seed phrase of the linked cryptocurrency wallet. If you forget it or lose it, the funds in your wallet will be irretrievably lost. Unfortunately, this is a fairly common situation in the cryptocurrency market.

There may be a loss of profitability due to changes in the pool volume. For example, a user stores funds that make up 10% of the total pool. If the pool size decreases, the revenue will also decrease. And it may lose profitability compared to simply storing funds in a cryptocurrency wallet (the so-called lost profit).

But, despite the shortcomings, interest in cryptocurrencies and decentralized exchanges is constantly growing, since crypto assets, especially decentralized ones, practically do not depend on the geopolitical situation and other external factors.

Published: 25 December, 2022