The 3 biggest dangers of being a DeFi liquidity provider, and how to avoid losing your funds

Welcome to the latest crypto DeSup blog from the Decentralised Support community, The Cake.

As you’ve probably heard, DeFi offers a lot of rich opportunities to the crypto savvy. Becoming a liquidity provider (LP) is one of these opportunities.

DeFi platforms, such as decentralized exchanges and lending platforms, are sustained by their respective communities and run on algorithms. As such, DeFi platforms do not hold your assets in custody, as banks or centralized exchanges do. Therefore, to be able to provide adequate liquidity for a wide combination of token swaps (for eg. Ethereum – Dogecoin), DeFi platforms rely on cryptocurrency users to ‘stake’ their ETH and DOGE into the ETH-DOGE liquidity pool, to act as a certain guarantee of funds, from which the other users may make their trades.

Users who ‘stake’ into liquidity pools are rewarded with a small percentage of the trading volume that happens within that pool. New pools, or pools with a lower amount of liquidity, tend to offer larger % rewards, and this is where LPs stand to gain very generous returns on their otherwise inactive cryptocurrency.

In a bull market where the price of cryptocurrency is trending upwards, it makes sense to both hold your crypto assets, and gain passive income from them.

But as always, where there is an opportunity, there is also risk. Fortunately, The Cake is here to help you identify and mitigate those risks.


1. Impermanent Loss

This kind of risk can be found on decentralized exchanges that are based on or similar to the design of Uniswap, the groundbreaking Ethereum DEX. In Uniswap liquidity pools, LPs typically have to provide 50% of each asset that is going into the pool.

For example, if you want to provide liquidity to a UNI – USDC pool, you’ll need to stake an equal amount (in dollars) of both the Uniswap UNI token and the USDC stable coin. As soon as the price of UNI changes relative to the more stable USDC, a liquidity provider begins to experience Impermanent Loss, which is called impermanent because it is temporary, only whilst the price deviates from that which the token was at when the deposit was made.

The more liquidity you have in the pool, the greater your % ownership, and the greater your risk of impermanent loss. But protocols like Uniswap are designed to mitigate against this risk by rewarding you with a larger % of fees, which in theory should compensate for any deviation in token price.

A better strategy is usually to choose a pool that offers a protocol token as an additional reward, for example, an MKR – ETH pool on Balancer that also rewards the liquidity provider with free BAL tokens. But the chance of impermanent loss is one of the main reasons that people who are new to crypto should seek advice before using liquidity pools.

2. Hacks

Just because no one person has the opportunity to shut down a DeFi platform, doesn’t mean that the protocol itself can’t have vulnerabilities in its code. In fact, the newer a DeFi product is, the more likely it is to have coding vulnerabilities that haven’t yet been detected by security measures like code audits or bug bounties.

Even the DODO decentralized exchange, which at one point was the 9th most popular DEX in terms of the total value locked up on the platform, was hacked for 2.1 million dollars in March 2021.

Considering how interconnected the world of DeFi is, especially on the Ethereum blockchain, the same problem can also apply to well-established and relatively safe protocols, if they interact with smart contracts on other platforms that haven’t been thoroughly audited.

Defisafety.com is a good general guide as to how safe DeFi platforms are, but new users should still do plenty of research into a project before interacting with it.

3. The Rug Pull

A rug pull happens when a developer sets up an exciting new crypto project that everybody wants to invest in or a liquidity pool that everybody wants to take part in, usually offering huge percentage returns. 

Once the price of the new token begins to grow, the developer sells off all of the tokens for the new project, taking away the lion’s share of the more valuable asset (ETH / USDC etc.) in the pool.

The price of the token plummets, but LPs find it difficult to sell their exciting new tokens, because there is no liquidity in the pool.

A recent example of this was the WhaleFarm rug pull, where investors lost an estimated 2.3 million dollars. The WhaleFarm DeFi platform, which had an anonymous team, was offering returns of over 7,000,000% APR in some pools, before the token price suddenly dropped by over 99% in a matter of minutes.

The best way to avoid becoming a victim of rug pull scammers is to be sceptical of huge percentage yields and promises of gains that seem too good to be true. 

The importance of getting advice

It’s not only useful to know what not to do in the world of DeFi, but also to learn the ropes of how to navigate this brave new decentralized world, which tokens to to look at, and how to get a reduced rate on gas and transaction fees.

Those who want to practice yield farming can use LP Royale – a gamified version of DeFi where you can try out liquidity pooling without the risk. No money, cryptocurrency or prior knowledge of blockchain technology is needed.

Those who have questions about the world of DeFi can find 1:1 support from one of the many vetted professionals that serve as advisors to the growing support community at The Cake.

Empowerment and Crypto-Knowledge: Content published on our website is intended to be used for information and education purposes. Please also keep in mind that presented information is as of a certain date and often based on current market conditions. Thus, it does not constitute financial, legal, accounting or tax advice.