Not too long ago, I had a wonderful discussion with my friend, Mark. He had become enmeshed in some DeFi project offering incredible APYs that defied reality. Blinded by the allure of high returns, he threw a hefty share of his portfolio into a liquidity pool. A week later, he was reeling. Impermanent loss, a phrase he’d seen on Twitter and maybe been able to describe on a quiz before, had wrecked his investment. He’d basically made a donation of his crypto to the pool. Mark's story isn't unique. These liquidity pools, which present thrilling prospect, are full of lurking, perilous pitfalls. Here are five missteps that will clearcut your crypto quicker than a bear market.
Ignoring The Impermanent Loss Monster
Impermanent loss (IL) is the silent killer of mercenary liquidity providers. Now imagine you think you’re making an awesome interest rate on your savings account. Then, all of a sudden, you find out the bank was sneakily taking your principal all this time!
Imagine x and y as two children on a teeter-totter. The protocol (the adult in charge) wants to ensure that the see-saw stays level (k). If one kid starts getting heavier, and the token price increases, the other kid has to start moving back toward the middle. This implies that there will be less of that token in the pool to rebalance. And the liquidity provider, that’s you, is the one moving the kids. This complicated balancing act is the source of impermanent loss.
For example, if you deposit $100 of ETH and $100 of DAI into a pool. ETH then doubles in price. Great, right? Not necessarily. The pool has rebalanced, and you no longer have 10 DAI and 1 ETH—you now have 5 DAI and 0.5 ETH. When you redeem, you should look forward to receiving $180 of underlying assets. That’s $20 less than the $200 you’d have if you simply redeemed the tokens and never spent them. That $20 difference? That's impermanent loss.
The greater the volatility, the greater the risk of IL. With current market conditions resembling a rollercoaster, you're practically begging for impermanent loss if you're not careful. And don’t be deceived by those unimaginable APYs. They rarely cover for the IL, particularly when the inevitable crypto winter arrives.
Blindly Trusting Pool Composition
Think of liquidity pools like a cocktail. Some are like a cold drink on a hot day (stablecoin pools), others are like Everclear (volatile asset pools). Putting your money in the wrong cocktail can result in one expensive hangover.
Stablecoin pools, such as USDC and USDT, greatly reduce exposure to impermanent loss. That’s because unlike most assets in the financial world, their underlying assets are built to maintain a stable value. Even these aren’t risk-free. Once a de-pegging event ensues, as we have seen in the recent UST instance, it can create shockwaves throughout the entire DeFi ecosystem.
Next are the meme coin pools – Shiba Inu paired with Dogecoin, you say? These are like Russian roulette. The potential upside is tempting, but the chances of you getting rug-pulled are statistically through the roof. As a quick reminder, a rug pull is when developers make a pool, encourage others to add liquidity, and then dip out with all the money. Poof! Your money is gone. Now, picture this—you make an investment in a company, and you find out that the company’s CEO has run off to the Bahamas. They’ve driven all the corporate money away with them!
Pro Tip: Avoid pools with low-cap tokens or projects with anonymous teams. Consult block explorers and token sniffers to identify the correct token’s contract address and history of liquidity. If a project seems too good to be true, it most definitely is.
Underestimating The Slippage Effect
Slippage is the invisible fee on your trades. Its the gap between the price you think you are providing and price you actually provide. Picture this—the government lets you order a pizza for $20, and then you have to pay $25 when it gets delivered. That's slippage in a nutshell.
Slippage occurs when the price moves against you because the size of your trade is too large for the size of the pool. Smaller pools are especially vulnerable. Even a small liquidity pool can be dangerous if one swaps so many tokens that the pool’s liquidity is eliminated. Otherwise, you may incur significant slippage costs that will devour your gains.
- Verify expected vs. received minimum before confirming a trade.
- Use limit orders where possible.
- Avoid large trades in illiquid pools.
- Consider splitting large trades into smaller chunks.
Ignoring MEV - The Invisible Thief
MEV, or Maximal Extractable Value, is sort of like having an invisible pickpocket following you around 24/7. MEV bots are highly advanced programs that constantly check the blockchain for pending (and public) transactions to front-run them and siphon off their profit.
They can detect your transaction before it’s included in a block. Next, they immediately place their own transaction in front of yours, to try to artificially move the price in their favor. It’s annoying when a person cuts in line at the supermarket checkout. They steal the last sale-priced blueberry muffin just before you get your hands on it!
- Split large trades into smaller transactions.
- Explore protocols that allow for private transactions.
- Avoid trading during peak network congestion.
Skipping Crucial Due Diligence
This should be the golden rule of any investment, but it’s particularly imperative in the wild west of DeFi. So before you take the leap and jump into a liquidity pool, be sure to do your research. Investigate the pool, the assets backing the pool and the team behind the pool.
Approach liquidity pools like you would any other investment – cautiously, skeptically, and with a healthy dose of due diligence. Don't let greed cloud your judgment. And as always, if something sounds too good to be true, it probably is.
- Is the project legitimate?
- Does the team have a proven track record?
- Are the tokenomics sound?
- Has the smart contract been audited?
Liquidity pools offer tremendous potential, but they come with significant risks. Know what you’re getting into, know your limits, and never invest money you can’t afford to lose. The future of DeFi is indeed bright, but only if you enter the world with both eyes wide open. So go out there and become a sophisticated liquidity provider.
The Bottom Line: Liquidity pools offer tremendous potential, but they also come with significant risks. Understand the risks, do your research, and don't invest more than you can afford to lose. The future of DeFi is bright, but only if you navigate it with your eyes wide open. Now, go forth and be a smart liquidity provider.
