Welcome to Kafycrypto, your number one crypto news, and marketing channel. This blog post is about liquidity pool vs staking.
There is no doubt, that the Defi space is growing and expanding Liquidity Pool vs Staking included. Individuals and Enterprises in the crypto industry want to capitalize on the benefits of decentralised finance. Not only has Defi come to stay but it has opened up financial inclusion all over the world and has made it possible for using and managing digital assets.
When it comes to Defi trading, liquidity pool and staking often time come up in discussions. The reason is that liquidity pool and staking are one of the popular ways in Decentralised Finance for getting plausible returns on crypto assets. Perhaps you have been an active trader in the crypto industry or you are just starting with crypto and you are looking for ways to earn passively from crypto, liquidity pool and staking are one of the ways you can do that.
Before we dive in on how they function, we will first dissect the meaning of liquidity pool and staking.
What is a Liquidity Pool?
A Liquidity pool in the crypto market is a pool of cryptocurrency locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (DEX).The purpose of providing enough liquidity is for buyers and sellers to trade each token at the most efficient price possible.
Liquidity pools are used not only by decentralised exchanges to swap tokens, but also for yield farming, blockchain-based online games, and borrowing and lending activities. As such, they play an important role in the Defi ecosystem. The common Defi exchanges that use liquidity pools on the Ethereum network containing ERC-20 tokens are SushiSwap (SUSHI) and Uniswap. At the same time, Pancake Swap uses BEP-20 tokens on the BNB Smart Chain.
How does the liquidity Pool Work?
A major part of a liquidity pool is automated market makers (AMMs). An AMM is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market where buyers and sellers are matched. In a traditional order book buyers and sellers submit their order and wait for their desired match before a transaction can take place, but in Liquidity pools, buy and sell orders are carried out no matter the time of the day and at whatever price without waiting for a direct counterparty.
Because the system uses an Automated Market Maker (AMM). You won’t need to find a seller to buy a token. All that is needed is sufficient liquidity in the pool. When a token swap occurs, the AMM makes sure that the price adjusts based on its algorithm. The algorithm controls the liquidity in the pool no matter the trade size.
A liquidity pool is a 50:50 ratio of 2 coins by default. For instance, let’s say a decentralised exchange(DEX) features a liquidity pool for trading ETH and BTC. Users who want to contribute funds to the pool would need to lock an equal amount of ETH and BTC into a smart contract.
Then a buyer who wants to purchase ETH from the liquidity pool can simply exchange the BTC they hold in their wallet for the available ETH in the pool, the same goes for a buyer who wants to purchase BTC.
Users who provide liquidity are called liquidity providers. They add the equal value of two tokens in a pool to create a market. In exchange for providing funds, liquidity providers are rewarded with a percentage of the fees that buyers and sellers pay for using the liquidity pool to trade tokens.
The fees are distributed proportionally to liquidity providers based on the amount of capital they contributed to the pool. Liquidity providers earn fees through Liquidity Provider tokens(LPt), which are tokens that represent their share of capital contributed to the pool.
Liquidity Pool vs Staking: How to make money from a liquidity pool.
Liquidity providers are users who provide the cryptocurrency in a liquidity pool hence by doing this they make passive income in a liquidity pool. They commonly make money in 2 ways.
Liquidity providers earn fees from transactions on the Defi platform they provide liquidity. The transaction fees are shared proportionally with all the liquidity providers in the pool, so the more crypto assets you stake the more fees you’ll earn.
For example, Uniswap charges a flat 0.3% transaction fee for every swap, and this fee is distributed proportionally to each investor in the liquidity pool.
Depending on the pool you’re invested in and the number of transactions on Uniswap, you can earn anywhere from 2% to 50% annual interest from liquidity provider fees.
Some pools also offer rewards for certain liquidity pools as an incentive to stake your cryptocurrency. These rewards are typically paid in the ERC-20 token used on the platform, so if you’re bullish on the Ethereum token that the protocol uses, these pools may be a good choice for you.
What are the Advantages of a liquidity pool
- It Simplifies DEX trading by conducting transactions at real-time market prices.
- It Permits people to provide liquidity and receive rewards, interest or an annual percentage profit on their crypto.
- It Uses publicly viewable smart contracts to keep security audit information transparent.
Liquidity Pool vs Staking: What are the disadvantages of a liquidity pool?
- The pool of funds is under the custody of a small group, which is against the concept of decentralization.
- Risk of hacking exploits because of poor security protocols, causing losses for liquidity providers.
- Risk of frauds such as rug pulls and exit scams which causes impermanent loss.
What is staking?
Staking is one of the ways to generate passive income in the crypto industry. It involves holding funds in a cryptocurrency wallet to support the security and operations of a blockchain network.
Simply put, staking is depositing your cryptocurrency for a fixed period, and in exchange, you earn some interest on the cryptocurrency you deposited.
You can stake your coins directly from your crypto wallet, such as a trusted wallet or from exchanges that offer staking services, such as Binance.
Staking functions in a similar way to interest accounts in traditional banking where you deposit some money in a fixed deposit and receive interest in return.
The traditional banks pay interest because they make use of the money deposited for loans and other investments. In staking, your cryptocurrency is put to use as well. The term is referred to as Proof of Stake(PoS).
PoS is a consensus mechanism that allows blockchains to operate more energy-efficiently while maintaining a decent degree of decentralisation.
In PoS, coins deposited are used to verify transactions on the blockchain. Transactions that are verified become new blocks on the blockchain.
What happens is that participants can lock their coin and at particular intervals, the protocol randomly assigns the right to one of them to validate the next block. Typically, the probability of being chosen is proportional to the number of coins, that is the more coins locked up, the higher the chances to be chosen.
This way, what determines which participants create a block isn’t based on their ability to solve harsh challenges, rather it is determined by how many staking coins are being held.
How to make money from Staking
Many reputable crypto exchanges offer cryptostaking services with an annual percentage yield of about 4% to 20%. These exchanges allow the staking of stablecoins such as Ethereum (ETH), Cardano(ADA), Solana(SOL), etc and in turn reward stickers with interest.
As a potential user or investor, staking is an excellent option to generate a crypto passive income.
What are the Advantages of Staking crypto
- There is potential for high returns (depending on the specific cryptocurrency you’re staking).
- The satisfaction of playing a key role in a project you believe in their proof-of-stake currencies.
- You don’t need any equipment for staking.
What are the disadvantages of staking crypto?
- The value of your staked crypto isn’t constant—as crypto prices are often highly volatile, your assets could sink in value with little warning, making it a much less profitable endeavor.
- Some proof-of-stake cryptocurrencies have lock-up periods, which means you won’t be able to access your crypto for a certain period.
- Depending on the approach you take, you might need to entrust your crypto to exchange so it can be staked, which can lead to security risks.
Whether you are an active crypto trader or just starting, Liquidity pool and staking are other ways you can earn passively in the crypto industry.
Here are some other articles that you may be interested in: