Top 5 Strategies for Choosing Liquidity Pools (2024)

Liquidity pools are ever more encompassing the “Fi” in DeFi. Be it a DEX, a lending or synthetic asset platform, liquidity pools are informing more and more of our decisionmaking in the crypto space. Choosing to invest in a liquidity pool isn’t something you should do lightly.

With the general proliferation of DeFi and the rise of Automated Market Makers (AMMs), there’s huge demand for liquidity providers.

We’re getting ahead of ourselves, though — let’s first familiarize ourselves with what liquidity pools are and how they fit into the ecosystem.

Trades between two kinds of crypto can’t happen unless the funds are there to make it happen. If a user wants to swap token A for token B, he/she has to go to a pool has already has both token A and token B. Liquidity is essentially the crypto assets/capital/funds (for explanations sake, any of these terminologies works) owned by liquidity providers but locked in a smart contract, and made availability for trading. This is why liquidity and — by proxy — liquidity providers are absolutely essential to the DeFi economy and the livelihood of DEXs the world over — they keep the whole system from ticking over.

For this reason, DEXs don’t expect you just to give liquidity out of the goodness of your heart. In fact, there are many rewards to be had by providing liquidity. This includes things like:

Trading fee rewards — if you provide liquidity to a pool and then a trade occurs within that pool, you get a cut of the trading fees.

DEX reward tokens — special DEX tokens may be given out so that holders can take part in governance as well sharing in performance fees, be granted special access and privileges, as well gain exclusive NFT access.

As such, we’ve compiled 5 strategies for choosing liquidity pools to help you make an informed choice that will pay off in the long and short term.

1 — Consider the daily trading volume

This is the first important aspect of liquidity mining. Since you take a percentage from each swap, the more swaps mean the bigger your profits. By looking closely at trading volume histories in the retrospective short and long terms, you can see how many trades have taken place and make an informed decision about whether that will continue.

2 — How much liquidity is already in a pool?

There’s often more than meets the eye with liquidity, and it often depends on the long-term health of a liquidity pool and your own goals. For example, if you envision a robust future for a liquidity pool, being an early liquidity provider and not having to share DEX rewards could be a huge boon. Of course, there are risks to this approach, so make sure you have good reasons to add liquidity to a pool that’s perhaps smaller than others.

3 — Harvest Health Ratio

This figure is a brand new concept introduced by Single Finance, which indicates the harvest healthiness of the pool based on 30-day annualized rates. The higher the HHR, the heavier the weight of the trading fees and yield farming components in the total return. The yields from the pairs with higher HHR are usually more long-term and sustained.

Leveraging this metric along with things like the ratio between pool volume and pool reserve over time can help you formulate and pivot strategy more efficiently.

4 — Be aware of token price divergence within a pool

Price divergence or impermanent loss is never great news. Impermanent loss is the difference between simply holding a crypto token in comparison to providing liquidity for the crypto token. The loss takes place only when a liquidity provider withdraws the Liquidity Pool (LP) tokens. The liquidity provider may still yield a profit after withdrawing LP tokens. However, if impermanent loss occurs, the profit would have be higher if they had just held the tokens in a wallet.

It sucks, but it happens. Thankfully, you can take steps to lower the risk of impermanent loss or at the very least, lessen its effects. Common ways are avoiding volatile pairings and being cognisant of how much trading fees can offset impermanent loss. However, one of the best ways to do this is to use an impermanent loss calculator — lucky for you, Single Finance already has one! It’s also important to analyse value shifts over time and keep track, so you can try to predict when the best time to add liquidity is.

Finally, understanding the difference between impermanent loss and price effect is really important. Price effect refers to the net equity value change due to changes in asset prices in the liquidity pool, compared to your principal. Impermanent loss refers to the “loss” when you deposited your assets to a liquidity pool to get a share in the pool (lp-tokens) followed by tokens’ price change, compared with simply holding the assets on hand. The former is an actual price change while the latter focuses on relative price change.

5 — Take your time

Liquidity pools aren’t going anywhere so there’s no need to rush without doing your homework. While providing liquidity might seem at first like an easy way to earn free money (and it certainly can be), there can also be risk for those who don’t take the time to inform themselves. The tools and information to make your investment profitable (ie. Single Finance’s LP Time Machine) are out there, make sure you use them — while keeping the previous four strategies in mind.

Single Finance is a super intuitive platform to all your DeFi investments minimizing correlations to the general market. Everything here is worked out from your injected capital in USD. Everything is visualized. And everything is within your fingertips.

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