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Liquidity pool (LP) is a smart contract containing crypto assets that provides liquidity to decentralized exchanges. By investing in liquidity pool one can earn passive income from the fees collected by the liquidity pool. Beside liquidity pools, crypto holders can earn passive income by staking their crypto assets.

What is a crypto Liquidity Pool?

In a decentralized exchange, there is no order book like centralized exchanges, e.g., Binance. To provide liquidity to decentralized exchanges, Liquidity Pools are created. Major aspect of liquidity pool is Automated Market Maker (AMM). AMM uses the liquidity pool to trade digital assets automatically rather than usual trading methods of buy & sell. AMM automatically calculates the current price based on the assets in the liquidity pool.

For example, in decentralized exchange, if the user wants to convert ETH to MATIC, they will just interact with liquidity pool, provide ETH and it will instantly convert to MATIC. There is no need to place an order and then wait for order to get filled. AMM ensures that transaction is instantaneous and at current market value.

Each transaction done via the liquidity pool is charged with a small fee. The fee is then distributed to all users that provided liquidity for the specific pool. Once liquidity is provided to the pool, no action is required from the user. This makes it one of the best ways to earn passive income in crypto.

How does liquidity pools work?

To provide liquidity for ETH-MATIC, deposit 50/50 split of ETH and MATIC to the liquidity pool. In this case, you will deposit $100 worth of MATIC and $100 worth of ETH.

Then you will receive ETH-MATIC Liquidity Provider Tokens (LPT). Deposit LPT to the ETH- MATIC staking pool. That’s it, now you will start earning fee from liquidity pools.

When any one will make transaction with ETH-MATIC liquidity pool, a small fee will be charged. The fee will then be distributed based on the LPT share in the staking pool.

Risk of investing in Liquidity Pools

No investment is risk free and investing in liquidity pools is no different. There is always a prevalent threat to funds being hacked due to poor security standards. To mitigate this issue, invest in pools managed by reputable decentralized exchanges.

Beside hacking, rug pulls and exit scams are also prevalent for new tokens. Malicious actors create liquidity pools for new crypto projects and offer insane returns. Once, enough liquidity is deposited in the pool, the creator of pool withdraws deposited funds without your permission. To mitigate this issue, always research carefully before investing in new projects or depositing funds in shady decentralized exchanges.

Since AMM determines price based on the assets in liquidity pool, large transactions on small pools can lead to huge swings in prices and this can cause impermanent loss. Impermanent loss is when your share in liquidity pool is changed due to high price fluctuation.

Best liquidity pool providers 2023

Popular liquidity pool providers include Uniswap, Curve, Balancer & Pancakeswap. All these decentralized exchanges offer various liquidity pools with attractive rates.

How much can I earn investing in Liquidity Pools?

APR is calculated based on the number of transactions happening on the liquidity pool. The higher the volume of transactions, the higher the fee paid to liquidity pool. In Bear market, the transaction volume drops significantly as compared to Bull market. Over an extended period, reliable liquidity pools can provide an APR in range of 4 % to 18 %.

Conclusion

Investing in liquidity pools can help generate sustainable passive income. A portion of portfolio can be dedicated to liquidity pools. To reap good rewards, it’s best to invest in Bear market so that one can get crypto at discounted prices. Once invested in liquidity pools, in Bear market, the investment grows two folds. One, the actual investment in crypto with increase in dollars as Bull market approaches. Second, fee collected will also increase as Bull market approaches. DYOR.

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