Don't Be a Liquidity Provider, Unless...

One of the trendy things to do in cryptocurrency is to become an LP (a Liquidity Provider). A lot of platforms offer massive returns for doing this, advertising 100+% interest rates, but you should tread carefully, because in most cases you'd be better off keeping your coins to yourself.

Let’s begin with an overview of the how and why of becoming an LP. How it works is you pick any two cryptos, and lock them up in equal proportion on a trading platform like Uniswap (say $5,000 in BTC and $5,000 in ETH). Once they’re locked up, you offer traders the ability to take some of your BTC and give you back ETH or take some of your ETH and give you back BTC. So if someone has $50 worth of ETH and they want $50 worth of BTC, you facilitate that trade and end up with $5,050 worth of BTC and $4,950 worth of ETH in your pool. 

You’re not doing this out of generosity; the trader pays you a tiny fee for your help (often 0.3%). Additionally, many platforms offer lucrative bonuses, paid in their own cryptocurrency, which is where the astronomical interest rates come into play. Sounds like a great deal, right? Well, there's a huge catch involved.

Impermanent loss

When you become an LP, you're betting that the two cryptos you deposit will generally move up or down together in price. If one of the two skyrockets in price and the other stays flat or falls, you'll have been better off just holding the two outside the pool. Same thing if one skyrockets in price but the other only goes up a little. The reason why is called "impermanent loss." (It's "impermanent" because there's always the chance your two cryptos will go back to their original proportion.)

The behind-the-scenes reason for why impermanent loss happens is simple. Remembering your BTC-ETH deposit, if the price of BTC skyrockets but ETH stays flat or falls, then greedy traders will give you all their ETH and take all your BTC, so instead of equal parts BTC and ETH, you'll be left with a LOT of stagnant ETH and just a little skyrocketing BTC. Worse, when they swap their ETH for your BTC, they'll do so at a cheaper-than-market price, because liquidity pools take a while to reflect the market price. So you would have been better off just holding ETH and BTC outside the liquidity pool.

The worst case scenario is contributing to a pool made up of ETH and a smaller token. If the smaller token goes to 0 after a massive hack or SEC investigation, then you'll end up with 100% of that worthless token and 0% of your valuable ETH.

I’ve contributed to multiple Liquidity Pools, being lured by the promises of high rewards, and while I had some weeks or months of profitability, most ended up losers in the long-run. The trading fees rarely made up for swapping the winning coin for the losing coin and it stung to see a coin I invested in hit it big, only to disappear from my pool.

Other risks

As if impermanent loss weren't bad enough, there are other risks. When you become an LP, you lose custody of your coins and trust them to someone else's code running on the blockchain. If that code has a bug in it, intentional or accidental, a hacker can swoop in and drain the pool. That has happened many times before. You can insure against this risk, using a platform like Nexus Mutual, but it's added expense that lowers your returns.

Making them work in your favor

Now that we've covered the risks of Liquidity Pools, here are five ways to make being an LP work in your favor.

First, if you can become an LP of two stablecoins, like USDC-DAI, or two coins that are mirrors of each other, like BTC and WBTC, then you don't have to worry as much about impermanent loss because the two should be interchangeable anyway. Finding those opportunities is harder and they typically don't last long, but they do pop up. For example, with incentives, PancakeSwap for a long time was paying 20-30% APR for being a USDC-DAI LP.

Second, you can obsessively trade your incentive bonuses for whichever crypto is rising in value. If you're pairing BTC-ETH and are earning an incentive, then by cashing out the incentive for whichever coin is rising disproportionately, you may be able to counter the effect of impermanent loss. Just keep a close eye on it.

Third, try and find pairs that should naturally rise and fall together or move in cycles together. For example, because PancakeCoin and BNB are connected at the hip (PancakeCoin is the biggest project on Binance Smart Chain), they tend to move together. And we've seen ETH and BTC dance around each other over time, with some periods BTC rising up more and other periods ETH rising up more. Still, just because two cryptos moved together in the past doesn't mean they'll continue to move together.

Fourth, you can use liquidity pools as a bet on stagnation. If you believe a coin will just stay the same price forever, then creating a liquidity pool with it and USDC will make you money over time.

And fifth, you can pool in emerging platforms that have figured out how to mitigate impermanent loss, like Bancor.

Popular places to become an LP

There are plenty of directories that let you browse LP opportunities. One is at Zapper and another is at the ever-reliable CoinMarketCap. If you do decide to become an LP, I recommend setting up a spreadsheet where you track how much of each coin you have every week, their prices, and how much you would have had had you kept them out of the liquidity pool. Like me, you might realize that you'd have been better off just staying out of it.