Investors in cryptocurrency are always on the lookout for new ways to grow and increase their investment, beyond the traditional methods of buying and holding. Two of the current most popular ways to generate passive income in the crypto space are staking and liquidity pools.
Both of these options offer the investor an attractive reward, but while doing this they come with their own unique set of risks. Understanding the basics of staking and liquidity pools is an all important first step to take before diving in.
In todays blog we will explore the potential benefits and drawbacks of stacking and liquidity pools.
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What is crypto staking?
Staking your cryptocurrency involves “locking” up a set amount of cryptocurrency tokens to support the operations of a blockchain network.
The most common type of staking is called Proof-Of-Stake (PoS). The most common blockchains that make this available to its users are Ethereum, Cardano and Polkadot. Using this method helps secure the network, while rewarding the participating user with additional tokens.
What are the rewards of staking?
- Passively generated income: By staking your cryptocurrency, you can earn rewards in the form of additional tokens, typically these offer an annual percentage yield (APY) ranging from 5% to 20%.
- Contributing to network security: Users staking their tokens help maintain and validate the blockchain network, adding to its overall decentralisation and security.
- Increased chance of asset appreciation: While you are earning your rewards for staking your crypto, you may also benefit from an increase in the base value of the assets you have staked over time.
What are the risks of staking?
- Lock-up time: Most staking services require the tokens to be “locked” for a set amount of time. While you can often select how long you wish to stake your tokens for, once you have them staked you are unable to retrieve the assets until this period is over. If the token jumps up in price while they are staked, you will be unable to un-stake and sell them.
- Crypto market volatility: Even though once your tokens are staked, you are earning rewards, the staked tokens price and still fluctuate drastically. This can potentially reduce the overall returns.
- Staking platform risks: If staking is done through a third-party or using DeFi protocols, there is always the risk of hacks and rugs pulls which could lead to you losing your investment entirely.
What are liquidity pools?
Liquidity pools are the backbone of all decentralised finance (DeFi). They allow its users to contribute an asset to a decentralised exchange (DEX) for trading.
A user will deposit pairs of tokens into their chosen liquidity pool (Such as ETH/USDT) and then in exchange they will earn fees from trades that are made within that pool.
What are the rewards of liquidity pools?
- Earning a trading fee: All liquidity providers (LPs) receive a share of all the transaction fees that are generated by the exchange, often returning higher profits than the traditional method of staking tokens.
- Yeild farming: Most of the DeFi platforms now offer extra rewards in governance tokens to encourage liquidity provisions.
- Zero lock-up time: Unlike when you stake your tokens, liquidity pools usually allow users to withdraw their assets at any time, making them far more flexible than staking.
- Passively generated income: Liquidity pools offer a “hands off” method of generating passive income from your cryptocurrency, allowing the user to not have to participate in the crypto markets.
What are the risks of liquidity pools?
- Impermanent losses: This will occur when the price of the assets you deposited changes compared to the time when you deposited them, potentially leading to a lower overall return than simply holding your tokens.
- Smart contracts are still vulnerable: DeFi protocols are still often targeted by hackers and bugs inside any smart contract can lead to significant financial losses.
- Transaction fees: On networks such as Ethereum, the high cost of gas fees can often cut into the profits made from the liquidity pool. This is even more of an issue during times of network congestion.
How can you reduce the risks?
- Diversify your assets: Spreading your assets across multiple staking and liquidity pools as well as multiple platforms can help reduce the risks.
- Do your research: Make sure you are only using well known, reputable platforms to stake your tokens or when joining their liquidity pools
- Keep up to date on the market: Try and reduce the risks you are exposed to by keeping up to date with the latest news on the various platforms. Don’t be afraid to change platforms or protocols for a better, more consistent rate of return.
Crypto Analyst‘s Final Thoughts.
Both staking and liquidity pools offer the average crypto investor an opportunity for passive income, as long as you proceed with caution and do your research.
Staking provides a more stable and predicable return, while liquidity pools can return a larger amount in a shorter period of time, but with that comes a much greater chance of financial losses. By looking over all your options and implementing a risk management strategy, you can protect your investment and earn a solid reward along the way.
Whether you decide to stake your tokens, or join a liquidity pool depends on what you are aiming to achieve. Hopefully todays blog has helped point you in the right direction!