Investing in the liquidity pools of swap applications has become an important trend recently. So much, so that crypto investors are closely following swap applications such as Uniswap and Pancakeswap and are competing with each other to invest in recently listed cryptocurrencies.

Rationale for Investing Liquidity Pools

So what are liquidity pools, and where does their attraction come from? Liquidity pools are created by bringing together a pair of cryptocurrencies of equal monetary value to be exchanged with each other. Let's say we have $1000, and we want to invest in the Ethereum-Bitcoin liquidity pool. We buy Bitcoin with $500 of our money and Ethereum with $500 and add them to the liquidity pool. The related swap application gives us a large portion of the commission income from trading the Ethereum-Bitcoin pair as returns. Trading commissions in swap applications range from 25 per thousand to 30 per thousand. Based on this income, the swap application provides liquidity pool investors with annual returns ranging from 10% to 500%. Therefore, those who invest in these pools benefit from both the possible price increase of the relevant cryptocurrency pair and the return of the liquidity pool.

Risk-Adjusted Return

The average return of liquidity pools varies according to the related platform's reliability and the cryptocurrencies to be invested. According to data from https://defillama.com/, there are currently 84 decentralized exchanges (swap applications) in the crypto world. When choosing the swap applications I will invest in, I consider criteria such as the total monetary value locked, the number of users, whether the application has passed the security check, whether the application has a unique aspect, and the speed of implementing innovations. For beginners, it would be a wise choice to choose swap applications such as Uniswap, Pancakeswap, Sushiswap, Mdex, whose crypto is in the top 100.
It is possible to express the risks of investing in the liquidity pool under three headings.

Price Volatility Risk:

It refers to the decrease in the value of the cryptocurrencies we will invest. Pools of emerging cryptocurrencies have higher returns but are equally have the risk of dramatically falling in value.

Impermanent Loss:

I mentioned that we invest in liquidity pools through a cryptocurrency pair. If one of the cryptocurrencies we invest in has a dramatic decrease in value, this causes the value of the other cryptocurrency to melt. Although the word 'impermanent' is used in the name of the risk, the losses are mostly permanent. We can calculate the risk of impermanent loss risk using this calculator: https://dailydefi.org/tools/impermanent-loss-calculator/ If the value of one of the two cryptocurrencies in the pool remains the same and the value of the other is halved, the temporary loss rate is 5.72%. If the value of one of the two cryptocurrencies in the pool remains the same and the value of the other drops to a quarter, the temporary loss is 20%. These rates refer to the extra monetary losses caused by the cryptocurrencies being in the pool.

Smart Contract Risk:

It refers to the risk that the swap application to be hacked or abused by its employees. Usually, either an insider steals the platform's cryptocurrency and sells it on the market or a flash loan attack. In both cases, the cryptocurrency of the respective platform suffers great losses. In any case, it is beneficial to invest in swap applications that have obtained security certificates.

Return Assessment

Return on investment in liquidity pools is measured by two metrics called APR and APY. Annual Percentage Return (APR) refers to the annualized estimated return on investment. APR is an estimate based on the assumption that the return on the investment in the previous days will continue for one year. On the other hand, the annual Percentage Yield (APY) expresses the annual return calculated by considering the additional income to be obtained by adding the returns obtained to the principal. Since compound interest is involved in APY, the rates are higher. I think making a comparison on the daily return will give a healthier result. Assuming an annual return seems a bit of a stretch to me because of the variability of rates of return.

Investing in liquidity pools just with high APR or APY expectations is not the right choice, in my opinion. Because the price changes of the invested cryptocurrency pair are more decisive on the return of the investment. My humble advice is to invest in pools containing cryptocurrency pairs that you already find attractive and believe in the growth potential.

Considering Market Trend

It would also be appropriate to consider the current state of the crypto market when investing in liquidity pools. In bull market times, it is possible to invest in pools of relatively high-risk cryptocurrencies. Or, if investments are made in several pools, some of them can be selected from high-yield pools. It would be more appropriate to prefer pools of well-known, reliable cryptocurrency pairs in bear market times. In fact, it is possible to make the investment more defensive by choosing one of the cryptocurrencies such as USDT, USDC, BUSD pegged to the dollar.

Conclusion

Liquidity pools have become fundamental investment instruments. Those who create a suitable portfolio where risks and returns are balanced will have an efficient passive income source.

Thanks for reading.

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