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Liquidity Pools On DEX Protocols Are Struggling To Show Its Worth In Value

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Cryptocurrencies and digital assets are keeping enthusiasts in a tangle, as market capitalization slipped by 7% after higher-than-anticipated inflation for August signaled the possibility of the Federal Reserve likely hiking interest rates again.

The single-digit decrease pushed total market capitalization just below $998 billion from its previous $1.07 trillion standing.

Across the crypto market traders and investors have been fleeing in all sorts of directions, as broader macroeconomic conditions are sending shockwaves throughout the digital assets industry.

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Headwinds In The DeFi Sector

Aside from bearish price movements, activity within the Decentralized Finance (DeFi) sector has undergone a number of headwinds in recent months which has now left many enthusiasts reluctant about forward-looking possibilities.

The wayward activity has signaled that many users are shifting interest as DeFi technology stacks begin to buckle under unpleasant conditions.

Although several projects make up DeFi activity, the majority of it revolves around liquidity pools at one or another level. Liquidity pools allow for decentralized trading, lending, and yield production, among other things.

Within these liquidity pools, there is generally a secondary level, whereby users can deposit tokens on top of an initial pool deposit.

To minimize confusion, think of the liquidity pool as a mechanism whereby users can trade between two crypto tokens. Users deposit the crypto tokens and try to match the value of the two different tokens in the pool.

The users who carry out the ‘staking’ or deposit will generally earn a proportional percentage fee for each transaction customers carry out within the pool using that token pair.

Usage Of Liquidity Pools

In recent years, the use of liquidity pools has become one of the central parts of the decentralized system, allowing many users to better trade and pair tokens as a way to increase their proportional fees. Platforms such as Uniswap or Sushiswap, among others, are some of the largest market pools.

This is where several questions come to mind, more so in particular, whether these liquidity pools are still a valuable tool for crypto traders and users who are looking to incentivize from staking.

A study by Bancor in 2021 found that more than 50% of liquidity providers on Uniswap were losing money due to impermanent loss (IL), a phenomenon that sees revenue generated in the form of fees being exceeded by dollar losses.

Many argue that this form of staking and mining tokens will remain an underpinned protocol of the decentralized exchange (DEX) for years to come. The use of automated market makers (AMM), a system of financial automation first discovered in the late 90s has helped fuel the popularity of decentralized protocols.

On the contrary, some feel that this form of liquidity mining and staking is dead, leading to new sub-sectors that focus on replacing liquidity pools and offering more substantial and financially viable solutions.

There are plenty of reasons why users may feel that liquidity pools are imprecise incentivization tools, which often attract mercenary farmers. In the same breath, a slew of other issues, such as token control and bribery among others are also shedding light on issues that have left liquidity pools to show their worth in value to users.

While momentum has been steadily growing, it’s perhaps the underlying issues that have been making the performance of these pools look profitable or financially attractive for users.

In a note to their users, Kamino Finance, a protocol that allows users to earn fees by providing concentrated liquidity said that “for liquidity pools and liquidity mining protocols to remain a valuable part of the DEX, technology stacks will need to be optimized to supply capital-efficient and deep liquidity, minimize impermanent loss and be user-friendly to the liquidity providers.”

Kamino Finance is a project incubated by Hubble Protocol, the DeFi platform that mints the censorship-resistant stablecoin USDH.

Creating Pools

Protocols are now looking to incentivize users by giving them the chance to create pools directly, allowing them to keep a portion of the trading fees from the pool. While this does create an additional revenue stream, it creates a sense of bias towards protocols controlling their pools.

Some argue that the activities which see protocols bribing users with creating their pools or similar projects are starting to have a knock-on effect on DEX's credibility and authority. This reflects directly on the prospects of liquidity pools, and how much longer they may be a suitable project within a decentralized finance ecosystem.

On top of these arbitrary flaws that have now almost become common practice, traditional issues that exist within liquidity pools persist such as access-based risks and smart contract risks. All of these have been major challenges for users to grapple with in recent times as this has resulted in unmanageable losses.

Although liquidity pools will not be going away anytime soon, users will need to remain bullish on existing projects that help to drive innovation and inclusivity within the decentralized protocol.

On top of this, users will also need to make more favorable judgments, that could perhaps re-instill trust and value into liquidity pools. Although many have turned a bearish sentiment towards these protocols, and the ecosystem has become awash with uncertainty, it’s perhaps more important to have multiple competing allied projects that can entice and incentivize users amore practically.