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The Complete Guide to Liquidity Pools

So, you’ve been poking around in the crypto world and you’ve stumbled upon Liquidity Pools. Oh no, you’ve thought…something else for me to decode! 

Don’t worry, in this article, we will take you through everything you need to know.

Are you ready?

Let’s dive in!

What is a Liquidity Pool?

A liquidity pool is a “basket” of a cryptocurrency token pair locked in a smart contract that is used to facilitate trades between that token pair on an Automated Market Maker (AMM) Decentralised Exchange (DEX). Liquidity providers allocate some of their holdings to a pool and are rewarded for doing so by receiving trading fees. 

Brief Introduction to AMM DEXs

Automated market maker (AMM) DEXs have been around since Uniswap was launched in 2018 and are designed to solve the low liquidity problem found on order book DEXs. 

To prevent low liquidity on AMM DEXs, they use liquidity pools instead of matching buy orders with sell orders (as order book DEXs do).

A Short Word on Liquidity.

It is important that at this stage we take a short pause to explain the concept of liquidity as this will help you understand the nuances of the different types of DEXs.

In short, liquidity refers to having enough of each cryptocurrency on an exchange to meet demand. If an exchange has low liquidity, it could be difficult to complete your transaction.

This is where Liquidity Pools come in!

How do Liquidity Pools Work?

Automated market maker DEXs (AMM) have taken Decentralised Finance (DeFi) to the next level. They allow on-chain trading without the need for an order book. As there is no matching of the buyer to seller and vice versa (as is done on an order book exchange), users can get in and out of trades on token pairs that could be highly illiquid on order book exchanges.

Rather than a buyer waiting to be matched with a seller (or vice versa), liquidity providers will have built up the pool of the token pair (at a predetermined ratio), so anyone wishing to trade that token pair will use the pool to make their transaction.

The liquidity pool itself is controlled by an algorithm that maintains the correct ratio of the token pair. The Price of each token for traders is also managed by the algorithm that adjusts the price in order to keep the correct ratio of the two tokens.

Example:

Say I had 1000 Token A and wanted to trade it for Token B, on an AMM DEX, all I’d need to do is enter the amount of Token A I want to trade on the DEX UI, which will then automatically calculate the amount of Token B I will receive. 

When I go ahead and complete the transaction, my traded amount of Token A goes into the pool and the amount of Token B I receive comes out of the pool and into my wallet.

What are the Benefits of Liquidity Pools?

Apart from the main use case mentioned above (enabling trading of a token pair on an AMM DEX), there are other benefits of providing liquidity to a pool. Liquidity pools were born out of necessity (combating low liquidity on decentralised exchanges) but they have been the birthplace of many DeFi products and passive income opportunities. 

More and more applications are being developed all the time but some of the standard ones include:

  • Liquidity Farming

  • Yield Farming

  • Governance

  • Insurance

  • Tranching and Minting Synthetic Assets

Liquidity Farming

So, why would anyone provide liquidity to a liquidity pool? If a liquidity provider is helping the DEX run, surely they deserve something in return, right?

Enter Liquidity Pool (LP) tokens!

Liquidity provider tokens are issued to liquidity providers on a decentralised exchange (DEX) that runs on an automated market maker (AMM) protocol.

When a user provides their tokens to a liquidity pool, they receive LP tokens in exchange. 

A decentralised exchange doesn’t hold any information about you, it only knows the wallet address where the liquidity came from, so the LP tokens act as a receipt. In this way, the DEX knows where to send the tokens if and when they are removed from the pool by the liquidity provider.

But, that’s not all, here’s the good bit!

For every transaction performed on an AMM DEX, a small percentage of the fee is taken as a liquidity provider fee. This percentage is paid to all liquidity providers of that pool in a pro-rata amount determined by the amount of LP tokens they hold.

As mentioned above, holding the LP tokens allows the DEX to know which wallet and how much to send to the liquidity provider.

Yield Farming

Because the LP tokens can be easily redeemed for the crypto of the pool they came from, and thus have intrinsic value, many DeFi protocols have started allowing users to yield farm using their LP tokens. 

True yield farming involves taking your LP tokens and putting them into another pool to earn further rewards. These rewards are often paid out a higher APY in a different (newer or more volatile) crypto token than those originally deposited.

In effect, the initial liquidity provided to the pool is working twice as hard earning the provider more passive income.

Governance

The very essence of DeFi applications is that they are not controlled by any one entity. This then brings up the problem of how changes to the application (upgrades, changes in procedure or fee structure etc.) are managed and decided upon?

In more and more applications, LP token holders have a voting voice in these decisions. They help run the application so it stands to reason they should have a say in how it is run. LP tokens enable this.

Insurance

Another product that is starting to make use of LIquidity Pools is insurance against smart contract risk (protecting users from losses that are not their fault or down to fluctuations in market price). 

What are the Risks of Using Liquidity Pools?

​​Impermanent (Divergence) Loss

Impermanent loss occurs when the price of the tokens provided in the pool initially changes, this means that it is both unavoidable and we can’t predict to what extent it will occur (hence the greater risk).

Let’s say for example that you deposited your liquidity in the ratio of 1 token A to 100 token B (1:100) and let’s say that the price of each token when you deposited them was; token A = $100 and token B = $1, you’d deposit 1 token A and 100 token B.

If the price of token A goes up to $1000, suddenly the ratio of the two assets has to change. This is because traders looking for an arbitrage will flood the pool with lots of token B and remove the corresponding amount of token A. In effect they are buying token A for $100, which they can then sell on other exchanges for its new price of $1000).

So the ratio changes and your initial liquidity is worth less. However, it is called impermanent loss because the loss is only realised if you remove your liquidity. 

If you never remove your liquidity or the price of both assets changes back to where it was initially, the effects will be reversed.

Smart Contract Risks

When yield farming with your LP tokens, you are placing your trust in the DeFi protocol and its underlying smart contracts. 

In the event of a hack or security breach, you could lose all of your LP tokens, and by extension, the initial crypto you put into a liquidity pool.

It is also to be cautious of any project where the developers themselves have to authority to change the rules of the pool.

Just because it is called decentralised, doesn’t mean it is. Sadly, this emerging financial ecosystem is not unaffected by scans and rogue players.

As we always say. Do your own research!

Final Thoughts

When it comes to DeFi, liquidity pools are the foundations upon which it is built. Initially invented to simply solve low liquidity issues found on centralised exchanges, they have now become the breeding ground of some amazing and groundbreaking DeFi applications.

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