Decentralized finance, or DeFi, has quickly revolutionized the crypto world. According to DeFi Pulse, more than $75 billion of value is locked in more than 130 different DeFi protocols. A core technology behind DeFi's meteoric growth is the concept of a liquidity pool, which provides the capital necessary to borrow, lend, and trade.
Let's look at what liquidity pools are, how they work, and how you can use them to generate yield.
Liquidity pools make it easy for crypto investors to generate yield on their long-term holdings while facilitating trading, lending, and other activities.
What Are Liquidity Pools?
Liquidity pools are funds locked in a smart contract to facilitate decentralized trading and other activities. Rather than matching orders between peers, decentralized exchanges (DEXs) use automated market makers (AMMs) and liquidity pools to execute trades. The result is less counterparty risk for lenders and easier access for borrowers.
In addition to powering DEXs, liquidity pools can serve as autonomously managed funds. For example, yield farming and liquidity mining apps, like yearn, use liquidity pools to generate yield. In addition, some liquidity pools influence governance decisions at decentralized autonomous organizations (DAOs), much like activist hedge funds.
New use cases are emerging every day, such as:
- Insurance - Liquidity pools could "underwrite" insurance contracts sold to individuals or businesses.
- Traunching - Liquidity pools could help segment financial products into categories based on their risk.
Liquidity Pool Example
Uniswap is a DEX that makes it easy for anyone to exchange ERC-20 tokens for a 0.3% fee. So, if you contribute $10,000 to a liquidity pool with $100,000 in total, you will receive a token representing 10% of the pool. You can redeem the token for a 10% share of the trading fees generated by providing liquidity to that specific ERC-20 token.
How to Generate Income
Liquidity pools make it easy for liquidity providers to generate a yield on their crypto holdings. For instance, an Ethereum HODLer could contribute their ETH to a liquidity pool to generate income over time. These capabilities resolve a common criticism of cryptocurrencies—their inability to generate yield like conventional investments.
Most liquidity pools integrate with a wallet, such as MetaMask, WalletConnect, or Coinbase Wallet. After connecting your wallet, you can transfer tokens to the protocol and receive incentive tokens. The income potential depends on the tokens you select and various platform-specific settings, such as Uniswap's fee levels.
The easiest way to get started with liquidity pools is using a liquidity mining protocol, like Yearn. Rather than dealing with complex trades, Yearn deposits your funds into boosted Curve pools spread across Compound, AAVE, and other liquidity pools based on their APY potential—creating a high-yield crypto savings account of sorts.
Most Popular Liquidity Pool Platforms
The DeFi ecosystem is rapidly evolving, with new projects and protocols popping up every month. When it comes to liquidity pools, many investors seek out those offering the highest APY, resulting in a lot of attrition. However, there are some mainstays that provide an attractive combination of income potential and track record.
The most popular liquidity pool platforms by dollar volume include:
Curve is the most popular DEX liquidity pool on Ethereum with a focus on highly efficient stablecoin trades. The protocol enables users to trade between stablecoins with low slippage and low fees. At the same time, the protocol supplies liquidity to Compound or iearn.finance where they generate more income for liquidity providers.
Uniswap is another popular DEX liquidity pool that converts ETH to any ERC20 token in exchange for a fee. Each liquidity pair is associated with one unique and transferable ERC20 token, and all fees are added to the relevant liquidity pool, providing income to contributors to the liquidity pool in proportion to their share of the liquidity.
In addition to liquidity pools, some protocols focus on allocating money to liquidity pools in a way that maximizes income. Yearn, for example, utilizes Aave, Compound, Dydx, and Fulcrum to optimize token lending for maximum yield. When you deposit tokens, they’re converted to yTokens that are periodically rebalanced to target the most profitable opportunities.
Key Liquidity Pool Risks
Liquidity pools help reduce the counterparty risks of centralized exchanges, but there are still some essential risk factors to keep in mind.
The most significant risk is so-called impermanent loss. While highly volatile tokens offer the highest APY, their relative value to U.S. dollars or stablecoins could significantly decline. As a result, the decline in value relative to stablecoins could exceed the increase in value from a high APY, resulting in unexpected losses.
Liquidity pools also rely on smart contracts that could have security vulnerabilities. For instance, the Poly Network suffered a $600 million loss after hackers exploited a smart contract vulnerability. These losses are typically split among all network participants, and they could be significant depending on the relative size.
The best way to mitigate these risks is by only staking tokens that fit within your risk tolerance and diversifying exposure across multiple protocols. In addition, some protocols like Yearn offer DeFi insurance policies, protecting funds against hacks and security exploits. But, of course, these costs eat into your yield.
Taxes on Liquidity Providers
The IRS considers cryptocurrencies property, meaning they're subject to capital gains taxes. While buying and selling Bitcoin is pretty straightforward, DeFi transactions and liquidity pools introduce more complexity. If you're not prepared, it might trigger unexpected tax liabilities that catch you off guard at year-end.
Suppose that you contribute to a liquidity pool and receive a corresponding liquidity pool token. From a tax standpoint, the IRS might consider that a taxable sale. Then, when you exchange the liquidity token for the original tokens, the IRS might consider it another taxable sale. These transactions can be a lot to compute if you have many of them.
Fortunately, ZenLedger aggregates these transactions across platforms and automatically computes your capital gains and losses. The platform then auto completes the IRS tax forms that you need, including Form 1040 Schedule D, Form 8949, and others. You can even integrate with TurboTax to complete taxes without worrying about accuracy.
The Bottom Line
Liquidity pools are a critical component of the DeFi ecosystem, enabling everything from DEXs to yield farming. While some liquidity pools are quite complex, Yearn and other liquidity mining protocols act as a high-yield crypto savings account, making it easy to generate income from your long-term crypto holdings.
