What are liquidity pools?
A liquidity pool is a decentralised exchange's crowdsourced pool of cryptocurrencies or tokens that are locked in a smart contract and used to facilitate trades between assets (DEX). Many decentralised finance (DeFi) platforms use automated market makers (AMMs) instead of traditional buyer-seller markets, which use liquidity pools to allow digital assets to be traded in an automated and permissionless manner. Liquidity pools are one of the most important technologies in the current DeFi ecosystem. To mention a few applications, they're employed in automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, and blockchain gaming.
In this article we will cover different parameters of evaluating the liquidity pools. To get started about the basics read the beginners guide to liquidity pool or if you already have an understanding, you can directly go to the compare the best liquidity pools article.
How to select the most suitable liquidity pools?
1. Volume of the liquidity pools
The daily pool volume is crucial to LPs since we only generate money when there are swaps taking place! Uniswap currently makes 0.3 percent on each transaction, thus the bigger the volume, the higher the profit.
2. Reserves of token in the liquidity pools
The liquidity pool's size is critical in ensuring that it is not vulnerable to extreme price movements. The lesser the reserves, the more vulnerable it is to price slippage, causing the price ratio to shift.
We also want to make sure the pool isn't made up of just a few whales, as this could have an impact on the pricing ratios if they leave.
We're interested in the ratio of this statistic over time because it will offer us an idea of the APY we may expect in the future. We want this number to rise (or remain constant) over time rather than fall (meaning you are earning fewer in fees over time).
3. Volume / Reserves ratio of the crypto token
We're interested in the ratio of this statistic over time because it will offer us an idea of the APY rate we may expect in the future. We want this number to rise (or remain constant) over time, rather than fall (meaning you are earning fewer in fees over time).
4. Price divergence of the crypto tokens
Impermanent Loss occurs when the prices of the tokens in the pool shift in opposite directions. This is referred to as price divergence, and it results in a temporary loss. When the price ratios move away from the original ratio at the moment you put in liquidity, the mathematical mechanism behind AMMs like Uniswap dictates that losses will occur. The greater the price divergence, the greater the impact of temporary loss (and thus leading to more losses when you exit liquidity).
6. Learn everything about the offering of the liquidity pools
You should investigate all available information on the pool you are considering purchasing. When choosing a liquidity pool, the best option is one that provides multi-asset liquidity as well as historical data. You should also see if you can change your preferred assets to fiat currency and then back to the platform.
7. Credibility of the team
Platforms should ensure that they are running on the most up-to-date industry solutions and have a robust security system in place to limit the danger of hacker assaults.
A bad security solution, for example, led to a money withdrawal by SushiSwap's CEO. Chef Nomi suddenly withdrew one-quarter of the project's developer financing pool in September 2020, a figure worth more over $13 million at the time, sparking outrage in the crypto community. Chef Nomi returned the cash and apologised after the accusations of fraud surfaced.