What Is A Liquidity Pool?
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Today, we will discuss what a liquidity pool is, how it works, and finally, some of its benefits and risks. A liquidity pool is basically a collection of funds locked in a smart contract. Liquidity pools contain a pair or pairs of tokens that facilitate trading, swapping, and other functions in a decentralised exchange. The tokens in a liquidity pool are provided by liquidity providers who are incentivised with the trading fees from all trades and swaps in the pool. It is worth to note that the trading fees earned are proportional to the total liquidity share of a liquidity provider. DeFi ecosystems use liquidity pools to solve the problems of illiquidity, speed, and convenience.
How Do Liquidity Pools Work?
Before we explain how liquidity pools work, let’s briefly look at how trades are carried out in CeFi. Centralised financial institutions make use of order books to facilitate trades. An order book is a collection of currently open orders for a given market. It contains both seller and buyer information, matching buyers with sellers. The seller information includes the quantity and amount they want to sell a particular asset. While the buyer information includes the quantity and amount they are bidding for a particular asset. When the offers of a seller match with a buyer’s bid, a trade will execute. So the order book is a peer-to-peer system matching buyers with sellers. However, a liquidity pool is more of a peer-to-code system that matches buyers or sellers with a smart contract. A liquidity pool is designed to incentivise liquidity providers to put their funds into a pool.
Let’s say you wish to provide liquidity to a dual token pool. That is a pool that contains just two tokens, usually in a 50:50 ratio. Let’s say the pool contains ETH and USDC, and you wish to provide liquidity of $4000. This means that you’ll invest $2000 ETH and $2000 USDC into the pool. You’ll be rewarded with liquidity provider (LP) tokens when you do this. Your LP tokens are usually proportional to the amount of liquidity you provide. LP tokens can also be reinvested and re-staked, but that is a more complicated process. Perhaps we’ll discuss that in another video. Because you provided liquidity, you’d be incentivized with trading fees and crypto rewards. These fees and rewards are also in proportion to the liquidity you provided. When someone comes along to swap some ETH for USDC in the liquidity pool, they will be charged a trading fee and this fee is automatically redistributed to all liquidity providers. Unlike centralised exchanges, a trader does not execute a trade with another trader in liquidity pools. Instead, she executes her trade with a smart contract. The smart contract used in liquidity pools is called an Automated Market Marker or AMM. Traders will interact with the AMM of the liquidity pool to execute their trade. Also, the AMM of a pool maintains a fair market value for the asset pairs in the pool. They do this by maintaining the price of the assets relative to one another in the pool. Ensure you watch our video on AMMs to better understand how they work. Your LP tokens must be destroyed whenever you wish to take back the $4000 provided in the pool. This signifies that you’re no longer a liquidity provider in that pool.
Benefits Of Liquidity Pools
Apart from offering liquidity for traders in a decentralised exchange, liquidity pools have other benefits like:
This involves staking your assets within a liquidity pool to generate tokenised rewards.
Some liquidity pools allow LPs to pool their assets together and put forward a governance proposal for the protocol.
Minting synthetic assets
LPs can connect a liquidity pool to an oracle to mint a synthetic asset pegged to a real-life asset.
Risks of Liquidity Pools
When you provide liquidity to a pool, you run the risk of an impermanent loss. That is the loss in the total value of your assets when you provide liquidity compared to when you simply hold your assets in your wallet.
Smart contract risks
If there is a bug or a hacker manages to hack the smart contract of the pool you provided liquidity, your funds could be lost.
In conclusion, liquidity pools are a powerful solution to liquidity in DeFi. Being a fairly new innovation, there are probably more uses of liquidity pools to be discovered.
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