We tell you the main pros and cons of the new way of earning, which appeared with the development of the topic of decentralized finance.
Despite the popularity of the term DeFi, it is far from easy for most new entrants to the crypto space to start using liquidity pools. This is due to their innovative operating principle.
The abbreviation DeFi stands for decentralized financial technology and in the broadest sense, almost any cryptocurrency fits this definition. We will talk about a narrower meaning of the term DeFi, about liquidity pools using automatic market making (AMM).
Most often, liquidity in the pool is provided in two tokens in a 50/50 ratio. By providing liquidity, the user receives a part of the commissions from all exchanges passing through the pool. However, potentially large profits come with potentially large risks. Identifying the key pros and cons of participating in DeFi, as well as practical advice for interested investors, will help you get started with the topic.
Pluses:
- Large interest per annum.
However, the indicated interest per annum in DeFi is not constant and depends on many factors. First of all, interest depends on the size of the liquidity pool itself - as the pool grows, interest per annum will fall.
Sometimes it happens very quickly. In a few days, the attractive 500% per annum declared at the time of entering the pool may decrease several times. The real profitability of a pool can be calculated only in the process of participation, so it is worth checking your investments periodically - suddenly the pool profitability has dropped so much that it ceased to meet the expectations and the disadvantages and risks of participation in DeFi described above.
It is worth paying attention to the price of the token in which the reward is paid. You can sell the received tokens both before and after the termination of your participation in the pool, depending on the market situation for the asset.
- Independence from centralized exchanges, third parties and no account verification (KYC).
DeFi operates on smart contracts, which means that no one can stop interaction with them. You can add and withdraw funds from the liquidity pool at any time at the click of a button. AMM swap (?) Will never ask you to take a picture with a passport in order to use the services, much less to confirm the origin of your funds.
- Education and ideology.
Additional benefits of participating in DeFi will also be the new knowledge and skills in blockchain technology that can be gained from providing liquidity to the pool. Successful investment in DeFi involves constant analysis of new pools, platforms and reallocation of funds between them, so the acquired skills may come in handy more than once in the future.
There is also a belief among proponents of decentralization as a global process that participation in DeFi is a socially beneficial undertaking. Since by providing liquidity to the pools, we allow other users the ability to exchange tokens "directly" without the involvement of third parties.
Minuses:
DeFi investor funds are locked in the pool's smart contract and are not listed on the exchange. This means that he will not be able to use the classic functionality of the exchange and the order system, which means he will not be able to set stop losses and take profits.
If the user's style of investing and trading involves the mandatory use of a stop loss, DeFi, at this stage of its development, will not suit him. However, it is likely that in the future we will see attempts by developers to bring the ability to use some kind of order for participants in DeFi pools.
Increased risks associated with fake tokens (coins masquerading as a real asset). Buying such a fake token is practically tantamount to losing money - you cannot sell it at the market price or use it in the liquidity pool.
Unlike large centralized exchanges, which have a complex process of checking and listing tokens, AMM swaps are open to listing anything and everything, so users are responsible for verifying assets themselves. One notorious example of fake tokens is TBTC on the Binance Smart Chain. As soon as the deceived users on the forums raised the alarm, the price of the "asset" immediately ceased to correspond to the price of BTC and today it is traded 7-8 times cheaper.
How to protect yourself from interacting with fake tokens? The risk will be less if you select only large tokens from the top of the list of proposed liquidity pools.
A full check will include going through the entire cycle of actions with a token with the minimum possible amount: buying, providing liquidity to the pool, checking the fact of interest accrual, disconnecting from the pool, selling a token, selling tokens in which interest was charged. If the test is successful, then you can start using a larger amount.
Increased risks are also associated with interactions with smart contracts. This category includes both the risks associated with interacting with a fraudulent smart contract through inattention, and the risk of hacking the pool's smart contract itself by hackers. No one is immune from the latter, and in the event of a break-in, there is a possibility of completely losing your funds.
In 2020 alone, DeFi users lost more than $ 100 million as a result of attacks on flaws in the code of projects. Conscientious developers try to pay compensation to victims, but this is a slow process.
No matter how unpleasant the hacks of DeFi platforms are, it is worth remembering that it is at such moments that projects have increased investment attractiveness - the token price that has fallen as a result of hacking can return to its original levels as soon as the vulnerability is eliminated.
An example is the altcoin RUNE, which was hacked several times in the summer. After a rapid fall, the price almost immediately returned to its original values. And at the time of market growth in August, it went up by almost 300%.
A significantly smaller disadvantage of participating in DeFi, despite the seeming danger at first, is non-permanent losses or Impermanent Loss. This concept means the difference in the value of assets when simply stored in a wallet versus participating in a liquidity pool.
In most cases, Impermanent loss is not a significant factor and, with sufficient time of participation in the pool, is compensated by rewards. However, in the event of a large divergence in asset price movements in a pool pair, volatile losses may increase.
The safest in terms of volatile losses will be pairs of two stablecoins, pairs with one stablecoin, and pairs whose asset prices move in a similar way. Special calculators help to simulate situations with impermanent loss. For example: Impermanent loss calculator.
Having experimented with the calculator, you can see that volatile losses become at least somewhat noticeable only when the difference in the price movements of two assets is more than several hundred percent. However, for example, if one asset in a conditional pair grew phenomenally by 200%, while the other barely moved and remained in place, volatile losses would be equal to only 13%. It is also important that almost all assets of the crypto market usually move in the same direction, which reduces volatile losses.
The last drawback of using DeFi on the list was the network fees for interacting with smart contracts. Ethereum network fees, especially during busy times, can be huge. For the entire cycle of actions required to participate in the pool, you can pay hundreds of dollars in commissions. For example, it will cost on average $ 75 to provide liquidity to the pool on Uniswap on the Ethereum network, and to withdraw your tokens from the pool, you will need to pay another $ 50.
For exploring DeFi and experimenting with small amounts, however, other blockchains may be suitable. For example, Pancakeswap on Binance Smart Chain or Justswap on Tron blockchain. Commissions for the entire cycle of operations with the pool for both of these services will be no more than $ 2-3.
Also, in order to pay less commissions, it is worth planning your actions in advance. Unlike a regular exchange, where you can cancel orders as many times as you like, in DeFi, in order to exit the pool, you need to interact with several smart contracts, paying a commission each time and waiting for the network to confirm.
It's also worth interacting with DeFi smart contracts during quiet times in the market. A network loaded at extreme moments is slower and more expensive to use.
