Investing in Decentralized Finance (DeFi) is one of the primary appeals of cryptocurrency, but it can be a difficult subject for some to understand when they take a closer look at just how complex the ability to be one’s own banker really is. 

Investors can be swarmed with a myriad of confusing options that range from lending and borrowing to more advanced investment strategies that include investing in liquidity pools as a provider or taking part in yield farming and token pairings. 

As the utilities of web3 and different crypto exchanges continue to expand, it’s important to know what is specifically available to traders because DeFi is falling under heavy scrutiny by the United States and many other countries that are drafting rules and regulations meant to protect investors. 

What is a Liquidity Provider?

In order for DeFi platforms to help execute transactions and provide benefits to users, the protocol must begin with a large amount of assets stored in liquidity pools. This allows the protocol to facilitate trades with fewer issues such as slippage and keeps order books sustainable. 

In most cases, investors are given the option to supply in these liquidity pools on DeFi platforms because it helps reinforce the protocol and allows it to scale upwards as more users join on. This can create numerous benefits for liquidity providers as they are rewarded by the protocol with incentive tokens as a way to keep their liquidity stored in the protocol. 

How to Invest in DeFi as a Liquidity Provider

Besides the technical complexities of web3 and liquidity pools, investing in DeFi platforms is not too difficult. Many platforms actually encourage the practice because it allows them to grow their business, providing more financial services to a larger audience.

However, risks are present and there is not always going to be someone to help if things take a turn for the worse. Storing assets into liquidity pools or other DeFi services crosses the custody threshold where your assets now belong to another entity because they are locked by a smart contract, but don’t mistake this for stealing. 

What it means is that, until an investor decides to remove their assets from a liquidity pool, assets are fully at risk to the overall health of the protocol. In the event that the exchange was to go bankrupt, any liquidity stored on their platform is subject to being lost forever whether it's because the funds have been mishandled or the value of the staked liquidity has hit zero; so, as always, it is essential to practice the rule of Not Your Keys, Not Your Crypto.

Popular DeFi Platforms for Liquidity Providers

When choosing a DeFi platform it is important to identify its strengths and weaknesses. Is it run by a team that has experience working in web3 or is it being led by a group of people with no known reputation? Further, how strong are the technical aspects? Does the platform work correctly? Are there any proof of reserves to prove that the protocol has liquidity? All of these are essential questions to ask when exploring the realm of DeFi because bankruptcies do happen and bad actors have created problems in the past. 

Once a number of reputable protocols have been identified, investors begin looking at their specific features and which one can provide the desired risk-to-reward ratio. This ratio can be noted by looking at yield percentages and interest to determine which might be the most profitable. 

Key Considerations for Liquidity Providers

It’s important to understand that DeFi protocols are still dependent on market conditions that pose a lot of additional risk to funds. Lending protocols are another way of using DeFi platforms to generate revenue, but they carry the risk of liquidation which can trigger during corrections or crashes. 

There are also tax implications and security threats to consider as well. The United States has already begun investigating DeFi and how it operates in order to draft a set of rules and regulations for protocols to follow in response to the extreme volatility of crypto and the high frequency of hacks and scams that target Defi platforms. 

Conclusion

While a risky proposition, investing in DeFi can be an interesting strategy for cryptocurrency users who want to invest in more advanced options than basic crypto trading or the unpredictable market of NFTs. 

Defi allows users to experiment and utilize high-powered investment strategies that are used by investment firms around the world so it's important to understand the complexity of what investors are interacting with because results can change drastically at any given moment.