Beginners Guide

A Beginner’s Guide To The Liquidity Pool Concept

Author: Sohrab Khawas

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    Those that are actively involved in the crypto space and keep up with the updates might have heard about Liquidity pools in the DeFi Ecosystem.

    However, only a minority of the population understands the concept. After all, What are Liquidity Pools, and how do they function? Why, in decentralized finance, do we need them?

    Liquidity pools provide a new standard to effectively trade shares while helping investors obtain a return on their investments.

    In this article, we will discuss how they operate, their primary advantages, and their overall aspects. Read on!

    What are Liquidity Pools?

    Liquidity pools refer to the pool of tokens locked in a smart contract. By offering liquidity, they guarantee trade and are used widely by some decentralized exchanges. 

    In simpler words, Liquidity Pools are the trading aspect of a decentralized exchange. Their role is to increase the market’s liquidity among market participants.

    Bancor made one of the first initiatives to incorporate liquidity pools, and Uniswap made it widely popular.

    Liquidity pools aim to address the low liquidity problem successfully and thus guarantee that the price of a token does not swing significantly after performing the order of a single large trade.

    Decentralized exchanges offer bonuses to those who invest in the liquidity pools to maximize customer engagement. The user has to deposit money into the liquidity pool to engage and reap the benefits. One or more smart contract protocols regulate them. The number of funds that need to be invested and the proportionate ratio of each token will vary between different DeFi platforms. 

    How do Liquidity Pools work?

    In its simplest form, a single liquidity pool contains 2 tokens, and each pool establishes a new market for the same pair of tokens. DAI / ETH may be a clear example of a popular liquidity pool at Uniswap.

    When a new pool is created, the first liquidity provider decides the initial price of the assets in the pool. The liquidity provider is encouraged to provide the pool with an equivalent value of all tokens.

    Based on the liquidity supplied to a pool, the liquidity provider (LP) receives special tokens called LP tokens in proportion to how much liquidity they supply to the pool. When the pool enables a sale, a 0.3 % cost is proportionally allocated to all LP token holders.

    They would burn their LP tokens if the liquidity provider wishes to get their underlying liquidity back, plus any unpaid fees.

    According to a deterministic pricing algorithm, each token swap encouraged by a liquidity pool results in a price shift. This process is also called an automatic market maker (AMM).

    A constant commodity market maker algorithm is used by basic liquidity pools such as Uniswap, which means that the quantities of the 2 tokens given still stay the same. On top of that, a pool will still have liquidity, no matter how massive the trade, because of the algorithm. The primary reason is that the algorithm asymptotically increases the token’s price as the target quantity increases.

    The Importance of Liquidity

    Liquidity is so important because it largely determines how an asset’s price can shift. A relatively limited number of orders are open on all sides of the order book in a low liquidity market.

    This suggests that one transaction could shift the price significantly, making the stocks unpredictable and unattractive.

    Liquidity pools are an essential part of the revolution of Decentralized Finance (DeFi), which appears to have great potential. Usually, these pools facilitate the swap of many assets with any other supported asset.

    How to Participate in a Liquidity pool?

    To deliver $50 of liquidity into an ETH / USDC pool, it needs a deposit of $50 worth of ETH and $50 USDC. So a total deposit of $100 is required in this situation.

    In return, the liquid provider will collect liquidity pool tokens. Such tokens reflect their proportional pool share and allow them to withdraw their pool share at any time.

    Anytime a seller places a trade, a trading fee is deducted from the transaction, and the order is sent to the smart contract containing the liquidity pool. The trading fee is set at 0.3% for most decentralized exchanges.

    For example, if you deposit $50 ETH and $50 USDC, you make up 1 % of the pool with your donation. You will then get 1 % of the 0.3 % trading fee for any trades.

    How do Liquidity Pool Exchanges work?

    There are two types of decentralized exchanges in the DeFi space at present which are:

    i) Order Book Exchanges: The order book exchanges depend on a bid /ask scheme to satisfy transactions. Orders get redirected to an order book when a new buy or sale order is made. Then, the exchange’s engine executes matching orders for the same price. Examples: 0x and Radar Relay

    ii) Liquidity pools Exchanges: They exclude the emphasis on order book dealing from the exchange. Thus, they enable the exchange to ensure the liquidity level is steady. Example: Kyber, Uniswap, and Curve Finance.

    Advantages of liquidity pools

    1) Guaranteed liquidity at every price level:

    Traders do not have to be directly connected to other traders because liquidity is constant as long as customers have their assets invested in the pool. 

    2) Automated pricing enables passive market making:

    Liquidity providers deposit their funds into the pool and pricing is taken care of by the smart contract.

    3) Anyone can become a liquidity provider and earn:

    Liquidity pools do not need any listing fees, KYCs, or other obstacles linked with centralized exchanges. If an investor wants to provide liquidity to the pool, they will deposit the equivalent value of the assets.

    4) Lower gas fees:

    The gas costs are reduced due to the minimal smart contract design offered by decentralized exchanges like Uniswap. Effective price calculations and fee allocations within the pool imply less volatility between transactions.

    Returns

    The returns from the liquidity pool depend on three factors:

     1) The asset prices when delivered and withdrawn,

    2) The size of the liquidity pool, and

    3) The trading volumes.

    It is very important to remember that, relative to what they originally invested, investors would actually end up removing a particular ratio of assets. This is where the market movement can either work for or against.

    Liquidity Pool Risks

    Like with everything in DeFi, we have to remember the potential risks. 

    • Impairment loss
    • Possible smart contract bugs
    • Liquidity pool hacks
    • Systemic risks

    If you give liquidity to an AMM, you must understand the concept of impermanent loss. So when you provide liquidity to an AMM, it’s a loss in dollar amount compared to HODLing. It might be small at times and significant at others. Remember to read our article first if you’re considering investing in a two-sided liquidity provider.

    Smart contracts come with their own risks. While no intermediaries are holding your assets, the agreement might be considered your funds’ custodian. As a result, your funds might be lost for good if there is a flaw or some form of exploit, including through a flash loan.

    Also, be aware of projects where the creators have the authority to change the pool’s regulations. Programmers may have an admin key or other privileged access within the smart contract code, allowing someone to do anything evil, such as seize control of the pool’s cash.

    Token

    Like all other tokens, a user can use the liquidity pool tokens during the period of the smart contract. A user can therefore deposit this token on a different platform that accepts the liquidity pool token to get additional yield to maximize the return.

    Therefore, the user can compound two or three interest rates using yield farming and increase their returns.

    Conclusion

    Liquidity pools offer an easy-to-use platform for both users and exchanges. Moreover, the user does not have to meet any special eligibility criteria to participate in liquidity pools, which means that anyone can participate in the provision of liquidity for a token pair.

    Thus in the DeFi ecosystem, liquidity pools play an essential role, and the concept has been able to enhance the level of decentralization.

    Well Done! You have now completed the Lesson.

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