What Is a Liquidity Pool? Liquidity Pools Explained

It is a smart https://www.xcritical.com/ contract written in a way that will hold funds, do math, and allow you to trade based on that math. In other words, users of an AMM platform supply liquidity pools with tokens, and the price of the tokens in the pool is determined by a mathematical formula of the AMM itself. A liquidity pool is a digital pile of cryptocurrency locked in a smart contract. Liquidity is a fundamental part of both the crypto and financial markets.

The Role of Crypto Liquidity Pools in DeFi

In doing so, it helps close the gap between the expected price and the executed price of an order while vastly improving efficiency and reliability. Constant product models, like Uniswap’s, are the most common approach to building liquidity pools. No matter how much the two sides go up and what is liquidity mining down, the product of the weights on both sides stays constant. Similarly, Uniswap and other protocols use the product of two tokens to set the price. One of the first decentralized exchanges to introduce such a system was Ethereum-based trading system Bancor, but was widely adopted in the space after Uniswap popularized them.

What Can I Do With A Liquidity Pool Token?

Also, what are the differences between liquidity pools across different protocols such as Uniswap, Balancer or Curve? Liquidity providers who stake their liquidity pool tokens may get paid in other tokens as a further incentive to provide liquidity there as opposed to another platform. Well, the protocol determines how much of its token it wants to print to sustain the yield. Liquidity providers received a percentage of trading fees in a particular pool. Liquidity pool rewards tend to decrease as more liquidity providers join, as per simple supply and demand. Liquidity pools were popularized by Uniswap, a decentralized exchange used by many in the DeFi world.

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The practice of seeking out the highest yield in various DeFi protocols is called yield farming; it can get pretty complicated, but it’s within reach for anyone wanting to learn. This is the primary difference between liquidity pools and liquidity providing, a contrast with blurred lines. The whole 0.3% trading fee (more or less, depending on the pool) paid by traders is distributed proportionately to all the liquidity pool providers. Since these exchanges are completely decentralized, they need access to a large number of funds to ensure traders always have access to the token pairs they need.

How much do liquidity providers earn from liquidity pools?

In traditional finance, liquidity is provided by buyers and sellers of an asset. A decentralized exchange (DEX) without liquidity is equivalent to a plant without water. First of all, as I mentioned earlier, the liquidity pool is filled with a bunch of funds provided by liquidity providers. When you’re buying or selling your desired coin on a liquidity pool, there is no seller or buyer on the other side, as we tend to have them normally with the Order Book. All your and pool activities are governed by the automated algorithm in a smart contract.

DeFi Liquidity Pool Example #1: Liquidity Pools on Uniswap

Now, I’ve mentioned coins and tokens – if you’d like to learn more about the differences between the two, don’t forget to check out the section “Coin VS Token”. Imagine that it’s a beautiful summer day outside, and you’re sitting in your room, all jolly and relaxed. Suddenly, you remember that you’re in need of a new laptop – your old computer is laggy and worn down, and takes about 26,5 years to turn on. Being in a great mood, you decide that it’s time to order a new laptop.

Liquidity Pools 101: How a Decentralized Exchange Works

Slippage is the difference between the expected price of a trade and the price at which it is executed. Slippage is most common during periods of higher volatility, and can also occur when a large order is executed but there isn’t enough volume at the selected price to maintain the bid-ask spread. Liquidity pools are one of the core technologies behind the current DeFi technology stack. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power almost every part of DeFi, and they will most likely continue to do so.

• Usually, a crypto liquidity provider receives LP tokens in proportion to the amount of liquidity they have supplied to the pool.
• Of course, the liquidity has to come from somewhere, and anyone can be a liquidity provider, so they could be viewed as your counterparty in some sense.
• Another advanced feature offered by liquidity pools is granting governance rights to LP holders.
• A liquidation call is the process where a trading platform forcibly closes a trader’s position because the margin account balance falls below the required maintenance margin.
• Liquidity providers are usually rewarded with fees, which can be a form of passive income.

Frequently Asked Questions about liquidity pools (FAQs)

When you’re ready to withdraw your assets, your liquidity tokens are burned (or destroyed), and in return, you receive a portion of the liquidity pool’s assets based on your share. Liquidity pools replace this order book with a simple mathematical formula that automatically determines the price based on the ratio of assets in the pool. This eliminates the need for traditional market makers and allows for efficient trading even with relatively low trading volumes. In this traditional model, a market maker creates markets by buying and selling crypto directly from crypto traders.

AMMs fix this problem of limited liquidity by creating liquidity pools and offering liquidity providers the incentive to supply these pools with assets, all without the need for third-party middlemen. The more assets in a pool and the more liquidity the pool has, the easier trading becomes on decentralized exchanges. There are many different DeFi markets, platforms, and incentivized pools that allow you to earn rewards for providing and mining liquidity via LP tokens.

Popular DeFi platforms like Sushiswap and PancakeSwap feature incentivized pools where users can earn platform tokens alongside trading fees. These incentives play a role in boosting liquidity and expanding user participation on the platform. The benefit of a liquidity pool is that it does not require a buyer to match with a seller for a transaction to occur. Instead, the system automatically uses the tokens in the liquidity pool to take the opposite side of a trade.

One of the first projects that introduced liquidity pools was Bancor, but they became widely popularised by Uniswap. If you’ve made it this far, congratulations– you’ve just learned about one of the most important components of decentralized finance. An APR like 110% APR, or even some as high as 90,000% or higher, isn’t an anomaly among other liquidity pools.

In this order book model buyers and sellers come together and place their orders. Buyers a.k.a. “bidders” try to buy a certain asset for the lowest price possible whereas sellers try to sell the same asset for as high as possible. Going to the actual Uniswap site, we see that the ETH-ENS pool generated $72,320 in the past 24 hours, which were all distributed proportionately to the liquidity providers.

The LP tokens can be redeemed for the underlying assets at any time, and the smart contract will automatically issue the appropriate number of underlying tokens to the user. Unlike traditional cryptocurrency exchanges that use order books, the price in a DEX is typically set by an Automated Market Maker (AMM). When a trade is executed, the AMM uses a mathematical formula to calculate how much of each asset in the pool needs to be swapped in order to fulfill the trade. For example, Balancer is a platform that currently allows up to 8 assets in a single liquidity pool—the math on that is crazy, but it shows the limitless possibilities of DeFi. A liquidity pool is a pool of money that contains both assets you are wanting to trade. For this example, we are going to be using ether (ETH) and Basic Attention Token (BAT).

And of course, like with everything in DeFi we have to remember about potential risks. Besides our standard DeFi risks like smart contract bugs, admin keys and systemic risks, we have to add 2 new ones – impermanent loss and liquidity pool hacks – more on these in the next articles. Curve pools, by implementing a slightly different algorithm, are able to offer lower fees and lower slippage when exchanging these tokens. Liquidity is a critical issue in a decentralized digital asset landscape, and developers have come up with some fairly ingenious and creative solutions. Educating yourself on DeFi liquidity pools and liquidity mining is like having a flashlight in your toolkit of exploring the next era of finance. As liquidity becomes a sought-after commodity, some protocols have taken it a step further to compete for liquidity providers by offering liquidity pool token staking, which we’ll get into below.

If you trade crypto assets, ZenLedger can help you organize everything for tax time. The platform automatically aggregates transactions across wallets and exchanges, computes your overall capital gain or loss, and generates the tax forms you need to file each year. Liquidity pools enable anyone to contribute tokens and become a liquidity provider.

Minting synthetic assets on the blockchain also relies on liquidity pools. Add some collateral to a liquidity pool, connect it to a trusted oracle, and you’ve got yourself a synthetic token that’s pegged to whatever asset you’d like. Alright, in reality, it’s a more complicated problem than that, but the basic idea is this simple. Likewise, buyers cannot devalue the market price below the average price. As a result, the transactions are smoother, and the market is more balanced.