Introduction
There are many ways to invest in and make money in cryptocurrency. I'm going to discuss liquidity provision as a way to invest in cryptocurrency. There are many advantages to liquidity provision and some drawbacks. I'm first going to discuss the other ways for background.
Long-term Holding
Long-term holding is by far the easiest way to invest in cryptocurrency. The idea is to buy preferably at a local low point, or dollar cost average, and hold for the long term. From a taxation standpoint, long-term holding is the easiest and in many countries capital gains tax rates are lower when selling happens after holding for a long time.
The drawback is that long-term holding offers no way to benefit from short-term market volatility.
Shor-term Holding Or Trading
Trading is potentially the most profitable way to make money in cryptocurrency but also the most difficult. Deep knowledge of technical analysis and understanding how whales manipulate the market is a must. It takes years to gain competence in trading and it is easy to lose money by trading.
From a taxation perspective, trading creates a lot of tax events and requires diligent accounting and the calculations can become complicated. Under some jurisdictions, losses cannot be deducted from gains when trading derivatives, which can result in catastrophic consequences.
Staking
Staking is simply holding cryptocurrency or tokens and staking them to gain a yield. Important considerations include lock-up periods that could make it impossible to sell one's coins at a market peak. From a taxation perspective, yields are considered taxable capital gains when they are gained possession of, and when they are sold, additional capital gains or losses must be calculated based on cost basis determined at the time of gaining possession of them.
Lending
Lending is similar to staking in terms of yield and tax consequences. But using centralized lending platforms comes with potential unknown risks. The key value proposition of cryptocurrency is the ability to self-custody one's coins and the security and impossibility of the coins to be confiscated or frozen. Allowing them to be possessed by a centralized custodian for a small percentage gain is often unjustifiable in my personal opinion.
Liquidity Provision
Liquidity provision means providing liquidity to a liquidity pool typically operated by a permissionless decentralized protocol. In exchange for purchasing coins to be swapped, the liquidity provider is given tokens that represent a share of the total value of the pool. The purpose of a liquidity pool is to allow coins or tokens to be exchanged on a decentralized platform without needing an order book. A liquidity pool is computationally much more efficient than an order book. The operating principle of a liquidity pool is very simple: the ratio of the coins in a pool determines their price relative to the other coins. The price is kept up to date by arbitrage between different market places. If the price of coins in any given pool is not aligned with their prices elsewhere, there is money to be made by purchasing the underpriced coin and selling it elsewhere for profit or vice versa.
Liquidity providers are incentivized by rewards paid by the protocol implemented by a smart contract. The users of a liquidity pool pay a fee for using the pool and the fees are paid out as rewards to the liquidity providers.
The main advantage of providing liquidity is the ability to earn rewards continually by simply purchasing liquidity pool tokens once. The only taxable income are the rewards earned whose cost basis is their value at the time they come into the possession of the liquidity provider. The reward coins can be immediately reinvested by swapping them for more liquidity pool tokens of the same pool, some other pool or something else, or they can be cashed out.
A liquidity provider benefits from the trading activities of the users of the pool without having to do all the work and with less risk. Traders are fully exposed to volatility while liquidity providers face a considerably dampened volatility risk. On the other hand, the potential rewards are smaller, too.
How To Choose The Right Liquidity Pool?
In my opinion, the choice of the right pool depends the stage of the market cycle at the time of investment and macro conditions in general. Close to the top of a bull market and during a bear market when the prices are going down, providing liquidity to a pool that has only stablecoins is the optimal choice. Stablecoin pools enable liquidity providers to gain yields, which merely possessing stablecoins does not do. At the end of a bear market or after a bull market has started but is not showing any signs of peaking, it makes sense to provide liquidity to a pool that has only non-stablecoins in it. That is how one can gain full exposure to the cryptocurrency market without giving up for a constant stream of yields.
Timing the market anywhere near perfection is impossible, which brings me to how dollar cost averaging is done in the business of liquidity provision.
There are three kinds of liquidity pools:
- Stablecoin/stablecoin pools
- Stablecoin/non-stablecoin pools
- Non-stablecoin/non-stablecoin pools
As discussed above, a stablecoin-stablecoin pool is best suited for bear markets and a non-stablecoin/non-stablecoin pools are best suited for bull markets where everything but stablecoins tends to go up. Where the stablecoin/non-stablecoin pools come in is in times when there is uncertainty as to whether the cryptocurrency market as a whole has already achieved a macro bottom (or a peak).
In my personal opinion, right now is a time when it makes sense to increase the proportion of one's funds in stablecoin/non-stablecoin pools relative to how much in the way of funds one has in stablecoin/stablecoin pools. It is still possible for a nasty surprise to cause the market to plummet one more time. Bitcoin is down about 76% from the last market cycle top. In the last two bear markets, the bottom has been found between 80% and 85% of the previous market top. There is also a degree of uncertainty in the general macro conditions and interest rates are still increasing. But there are also encouraging sings of consumer price inflation going down. A significant downturn of the market may never materialize in this cycle and the market could be poised for more sideways action until the next bull market.
One thing worth noting about liquidity pools containing a non-stablecoin component is that if, under your jurisdiction, losses from derivatives are not deductible from gains, it might be prudent to only invest in that type of pools when you have a high degree of confidence in a bull market having begun as selling liquidity pool tokens at a loss might not result in a deductible loss. The upside is that there will not be many such tax events in any case and calculating the losses in case one is forced to sell is simple.
Auto-compounding means not having to manually re-invest yields in the same pool. You'll also save on transaction fees. It is unclear to me how auto-compounded yields are treated from a taxation perspective. It would make sense to argue that they are like yield funds in traditional finance where there the yields are automatically re-invested and where there are no tax consequences before cashing out. But to make sure, you should ask your local tax authority how they treat auto-compound yields from a liquidity pool.
If you provide liquidity to a non-auto-compound pool, it makes sense to decide a schedule and stick to it. If your transaction fees are low relative to your yields, you can compound daily. If your transaction feeds are high, you can and should compound less frequently.
Risks In Liquidity Provision
Liquidity provision is riskier than simply holding coins as it involves giving control over one's coins to a smart contract while involving the exact same risks when it comes to properly storing private keys as when simply holding. The contract might have bugs and the platform one transacts with might have components that aren't fully decentralized.
Conclusion
In my personal opinion, current market conditions favor liquidity providers to traders by a considerable margin. The yields are high as are the trading fees. But even lower yields and lower fees would justify providing liquidity to just holding coins so long as one chooses a reliable platform.
P.S.
The Multi Token Bridge is a convenient tool with which to swap your tokens on the Hive blockchain for wrapped tokens of values pegged to them on the Binance Smart Chain (BSC). Cub Finance, which is an interface to Pancake Swap built by the LeoFinance team, has many pools in which you can use to trade your tokens and swap them for a very large number of coins and tokens either native to to BSC or wrapped coins on it. You can also use Cub Finance to provide liquidity to many pools with wrapped Hive tokens on them to help increase the reach of the Hive ecosystem and to earn yield.