How to create passive income using Liquidity pools!
The crypto space is large and fast. If you only close your eyes for only a little too long, you'll miss the opportunity to profit, or you will miss out on gains. There are many opportunities, some better than others, to make your funds and crypto work for you. This crypto will make you more crypto, and if you'll give it the time it needs to compound it starts to make you more and more passive income. Sadly, a lot of people that are invested in the crypto industry don't even know about some of their options, so that's what I'm here to teach you.
Money makes money. And the money that makes money makes money. — Benjamin Franklin
I suspect that most of my readers here own crypto, but also that too many of you don't know what passive income and profits you can create with your funds! In this article, I will explain what liquidity providing is, and what the most common seen Liquidity Providing (LP) strategies are with all of their advantages and disadvantages. If you have some static crypto laying around, providing liquidity is a great way to generate some passive income without too much effort!
How to profit from Liquidity Providing (LP)
Most Decentralised Exchanges (Dex), like Uniswap, spookyswap or Pancakeswap use Automated Market Makers (AMM) where investors interact with a smart contract to exchange funds. This AMM has a liquidity pool, where both sides of the assets live. One side contains, for example, Ethereum and the other side USDT. A trader might deposit USDT on one side of the pool and withdraws ETH on the other side. While making this transaction, a small percentage is paid in fees to reward the provider of this liquidity.
This is where our profit will come from! By supplying our static assets in a Liquidity pool we will get a portion of the fees every time a trade is done. This way our crypto will earn us more crypto! The yield is depending on your portion of the whole liquidity pool, as well as the volume in the pool. Having a larger share of a pool with a lot of volumes will give us the most rewards!
What are the risks?
There are many strategies, all with their pros and cons. The rewards you receive are usually linked to the risk, so the higher the rewards, the higher the risk! High risk means that you have a large exposure to potential Impermanent Loss (IL) and/or price volatility. This is the loss you’ll have when providing liquidity instead of holding the asset. When the price of (one of) the asset rises or falls, it would have been smarter to hold or sell that asset, instead of Providing liquidity. However, when the price returns back to the original price, the loss has now been undone; therefore the term Impermanent loss. It is not a loss when the price returns to the original price, therefore being impermanent. Read this article from yahoo.finance to get a better understanding of IL.
Liquidity providing strategies
To get the information from this overview I am using the website Coindix.com, where an amazing overview of all the different pools and their returns are stated. The website provides a great overview of a lot of assets and their options, so it should be easy for you to find out what pool is perfect for you! There are many more Dapps that offer investment options, so I would advise you to also look further than just this website.
Risk level: Low— APY: 2–50%. The safest and least risky Liquidity pools are the ones that consist of stable pairs. You can think of stable pairs with stablecoins on both sides, like USDT/USDC, but also with the same asset on both sides, like stETH/rETH. Your exposure to IL is minimal as both sides are tracking the same asset, so ideally they will never run apart. I would recommend investing in these kinds of pools when you are new to DeFi, as this is as safe as Liquidity providing can get!
Common Asset Pools
Risk level: Medium— APY: 20–100%. Coming to the riskier side of the pools, we have pools that have a stablecoin on one side and an asset on the other one. You can think of pools like USDT/ETH or DAI/MATIC. The good part is that almost every token in existence has a pool like this! If you have some crypto and stables laying around, this is a perfect way to make your crypto work for you! The IL risk is higher, but as you are already exposed and (probably) bullish on this coin, it's a perfect way to make some money while you HODL.
Volatile Asset Pools
Risk level: High— APY: 20–2000%. The riskiest pools are the pools that have volatile assets on both sides. The risk of Impermanent loss is highest in these kinds of pools, and therefore the locked value usually is low. This means that it's easy to get a large share of the pool by providing liquidity, therefore returning a lot more rewards as well! But be careful, as the chance of the assets running away is high and therefore IL occurs often and fast. I don't recommend this option to most people, and you should only invest in these if you have trust in both assets!
Risk level: High— APY: 1–400%. Some protocols offer their own native token when providing the desired Liquidity. Platforms like Geist finance (FTM), valas finance (BSC) or AAVE offer their native token in exchange for your LP tokens. By supplying liquidity to the desired DEX and then depositing those LP tokens on their platform you will receive boosted native rewards. Some of these tokens plummet in value as they are used for farming as well, and as some protocols have a vesting period before you're able to withdraw your rewards it might have been better to invest in some other pool.
Risk level: Medium — APY: 2–20%. Some platforms offer single-sided liquidity pools. This means that only one asset has to be provided. These pools are ideal if you want to use your assets to make some passive income, but do not want to be exposed to the risk of Impermanent Loss. Bridges are a common type of Dapp that only need 1 asset for liquidity, as that single asset liquidity is then used to transfer to other chains.
I hope this guide to your first liquidity pool has been helpful! I'm trying my best to show you the best ways to invest and, probably even better, show you my ways of making money using your crypto! There are many different investing profiles, and the options mentioned above will give a good idea of the possible investing possibilities. I will always advise spreading your investment in multiple streams, that way you keep yourself from exposing yourself to too much risk and it will diversify your portfolio.
Take a look at my other articles to read more about sustainable passive income streams and investing options! You can always follow me for future articles about investing and passive income using crypto. If you have any questions feel free to comment or respond!
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