What is Liquidity Pool – Benefits, Importance & How it Works?
15 July 2022
Liquidity Pools (LP) form the backbone of decentralised crypto exchanges. They are used to facilitate decentralised trading, lending, and many more functions that are based on the blockchain algorithm. The users of liquidity pools offer LP tokens for the purpose of creating a market. In exchange, they earn trading fees from the transactions taking place in the pools.
There are multiple crypto exchanges whose operations are completely based on liquidity pools, for example, Uniswap, Balancer, Curve, etc. To understand what a liquidity pool is in detail, keep reading.
What is Liquidity Pool?
A crypto liquidity pool (CLP) refers to a collection of tokens that are locked in a smart contract. Liquidity pools form the core of the decentralised finance (DeFi) ecosystem. They help in facilitating decentralised lending and trading across various crypto exchanges.
The primary aim of a liquidity pool is to remove the issues related to illiquid markets that are governed by centralised systems. The users of liquidity pools are offered a portion of the trading fees based on the percentage of liquid funds they provide for the pools.
How do Liquidity Pools Work?
Here are the steps that showcase how crypto liquidity pools work:
Step 1: Two tokens or cryptocurrencies form a liquidity pool, for example, Ethereum and Bitcoin.
Step 2: The creator of this pool ascertains the initial price of each asset. That said, if this value doesn’t match the price of the global cryptocurrency market, LPs can lose money.
Step 3: More liquidity providers add funds to the pool while ensuring that the value of the tokens is in line with their market price.
Step 4: The pricing algorithm adjusts asset price while the CLP supports token swaps. The value can be ascertained by each liquidity pool utilising its individual methodology.
Step 5: Irrespective of the size of the trade, the AMM algorithm makes sure that there’s sufficient liquidity.
Step 6: The pricing of the pool is ascertained by the token ratio. For example, if someone buys BTC from a BTC/ETH pool, the volume of ETH increases, which affects the price of both crypto tokens.
Step 7: Overall price adjustment will be based on the amount that has been spent and how much that has altered the pool. That said, large-sized pools exhibit lesser price variations.
Step 8: Users of the pool are charged a transaction fee that is used to pay the liquidity providers. However, these charges are reinvested in the pool, which helps in increasing the value of the tokens and expanding the pool.
Benefits of Crypto Liquidity Pools
These are a few benefits that come with crypto liquidity pools:
A crypto liquidity pool makes DEX trading hassle-free by enabling direct transactions at real-time market prices.
CLPs enable individuals to offer liquidity and get rewards, interest or a percentage yield on their digital assets.
CLPs allow traders to buy and sell digital assets without the fear of incurring losses due to liquidity issues.
LPs utilise smart contracts that are publicly viewable. As a result, audit details remain transparent.
Experienced traders who have bought and sold digital assets in the crypto space know the risk of entering a market that has low liquidity. In the case of a cryptocurrency that has a low market capitalisation, slippage is a concern that one should take into account at the time of exiting or entering a trade.
Slippage refers to the difference between the estimated price of a trade and the value at which the trade is executed. Slippages are common when there’s high volatility in the market.
That said, low liquidity can lead to increased slippage, and the final trading price can exceed the initial market order price by a significant margin. Additionally, if there’s not enough liquidity for a trade, then users won’t be able to exchange their tokens. This is where liquidity pools come to the rescue. They help to keep the financial systems of a DEX running by providing smart contracts. The contracts contain locked crypto tokens that have been supplied by the platform’s users. This ensures sustainable liquidity in the DeFi ecosystem, which enables the users to buy and sell tokens on exchanges readily.
What is the Role of Crypto Liquidity Pools in DeFi?
CLPs play an extremely vital role in decentralised exchanges (DEXs). They offer speed, convenience and liquidity to the decentralised finance ecosystem. Users can utilise the mechanism of a liquidity pool to accumulate their assets in the form of smart contracts in a DEX. This would offer asset liquidity to traders and enable them to swap between different currencies.
Unlike centralised exchanges, DEXs are powered by the AMM (Automated Market Makers) computer programme. The programme lets anyone create a market in a decentralised exchange by depositing cryptocurrency into a liquidity pool.
Before the introduction of AMMs, crypto liquidity was an issue for DEXs. DEXs had a complex interface, and the number of traders was also low. As a result, it was not that easy to find adequate people wanting to trade regularly.
However, after AMMs entered the market, they solved the issue of low liquidity by forming liquidity pools and giving providers incentives to supply such pools with assets without involving any intermediary. Trading on decentralised finance exchanges has now become straightforward and easy due to the high liquidity associated with liquidity pools.
Liquidity pools are one of the main technologies in the DeFi ecosystem at the moment. Their growth indicates a positive outlook for DeFi and cryptocurrency. CLPs can open the crypto space to more consumers and eliminate concerns related to volatility in the crypto market.
Q1. What are some use-cases of liquidity pools?
Ans:Here aresome of the best use-cases ofliquidity pools: • Liquidity mining/yield farming • Efficient governance • Tranching, which involves categorising financial assets based on their risks and returns. • Minting synthetic assets
Q2.What are some risks associated with a liquidity pool?
Ans: Risks associated with liquidity pools are as follows: • Access risks: There’s a possibility that developers might haveadminaccess within the smart contract code. They can use it to alter the regulations of the pool or engage in some malicious activity. •Temporary loss risks: There’s a possibility of incurring temporary losseswhen one offers liquidity to any AMM. Besides these two, one should be aware of the smart contract-based risks.
Q3. What are some drawbacks of liquidity pools?
Ans: Here are some major limitations ofliquidity pools: Possibility of frauds (exit scams, rug pulls, etc.) The possibility of hacking exploits owing to below-par security standards Exposure to impermanent loss
Q4. Can you lose money in a liquidity pool?
Ans: Liquidity pools are prone to impermanent loss. If the ratio of the deposited tokens in a liquidity pool becomes uneven due to market price fluctuations, this could result in significant loss for the investor. This loss is referred to as impermanent loss.
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Disclaimer: Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions.
Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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