Liquidity Provision in Decentralized Finance: Risks and Strategies

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The world of Decentralised finance is really growing rapidly beyond what we can ever imagine of. At least we are not where we are years ago and that is to show the rapid growth. Decentralised finance has been able to shape a lot of the financial world and I am so sure it will continue to get better and better in years to come. For every Decentralised finance to thrive, there must be the liquidity available so that it can offer a lot of opportunities and also been able to actually carry out the financial services.

Even though liquidity goes a long way to give massive opportunities just like I said, I believe strongly that it also comes with a lot of risks attached to it which I believe most of the time we did not pay attention to. Today I will be talking about some of them below. So stay tuned.

First I will like to establish a strong understanding about liquidity provision in the DeFi world. Liquidity provision have always go a long way in helping to supply assets so that traders involved in the various Decentralised platforms to be able to carry out those transactions that is needed and it made it possible without the need for centralised intermediaries.

Of course we have a whole lot of platforms that support the liquidity pools I am talking about. We have the Uniswap, the balanced and many more. Every liquidity pools function because there is something called the liquidity providers which are called the LPs. Those LPs helps to supply liquidity by locking their asset and in return earn rewards which can come in form of tokens or rather in form of reduce transactions fees.

Even though liquidity provision have a whole lot of advantages it offers as it been the solid foundation on which the Decentralised finance thrives on, but even with that, there are still some risks attached to it which I believe needs to be looked into.

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The first is the aspect of Impermanent Loss. Impermanent Loss works in a way whereby there is massive reduction in the price value of those assets that is locked or should I say that are staked. One of the major reason behind this is when there is a massive price Fluctuations or the market Volatility. Even though sometimes the transaction fees can reduce the impermanent loss but also sometimes it is a massive risk most especially for the liquidity providers.

The second risk involved which I want to talk about is the aspect of smart contract vulnerabilities. As many of us knows and is aware of, the world of DeFi works on smart contracts so that those transactions can be carried out automatically. But whenever there is a bit of vulnerability in the code for the smart contracts, it can lead to massive loss of funds and cyber criminals activities because it can even leads to hacks also.

The last risk I will like to talk about is the aspect of market volatility. Market volatility is something that every liquidity providers can not avoid because the crypto market on its own is volatile. Most of the time, the crypto market volatile can affect the value of liquidity providers and this can even reduce the rewards that those liquidity providers should actually get. Well looking at these few risks I have discussed above, it can't be avoided.

It will not make sense if I talked about the risk and I didn't not discuss the strategies I believe can help to mitigate those risks below which I will be discussing below.

The first is if you are a liquidity provider, make sure that you always choose stablecoins pools as that will help to give you massive edge. When you are able to choose stablecoins pools, even though you might not get the rewards as other liquidity providers, but it will give you massive edge over some risks like the market Volatility and the Impermanent Loss because you are dealing with stablecoins who always have a massive edge over the volatility and price Fluctuations.

The second strategy I will like to talk about is you Diversification of your funds across protocols. Like they always say, it is not always wise to put your egg in one basket. Same thing. Try to make sure that you engage in Diversification so that you can spread your funds across lot of platforms and poos do that you will be able to have a massive edge over the smart contracts risks I discussed about. There are also some other ways like you leveraging on the yield aggregators, and making use of something called the Impermanent Loss insurance.

As I conclude, liquidity provision is essential to the growth and sustainability of Decentralised finance. Even though there are risks involved most especially for the liquidity providers, but I believe there are also things we can put in place to overcome those risks at the end of the day.