A liquidity pool is a collection of cryptocurrency tokens locked into a smart contract. Learn more about how it works?
If you do crypto, you must have heard of PancakeSwap or SushiSwap earlier, right? These are liquidity pools or funds that keep decentralized finance protocols operating. Yet, how exactly do crypto liquidity pools work? Are they safe? What their uses are? We’ve broken it all down below!
How do LPs earn money?
A liquidity pool is, in essence, a type of smart contract within which crypto tokens are locked. Anyone can add funds to a pool and no direct counterparties are needed for trades to be executed successfully. So, there is no peer-to-peer trading, which is typical for centralized exchanges.
And then, automated market makers (AMMs) arrive on the scene. AMMs make it possible to execute trades regardless of whether there are other people interested in making trades at the same time. So, users are not interacting with other users but with the contract meanwhile activities within the pool are governed by the algorithm.
The only imperative to execute a trade is that a liquidity pool has enough liquidity per se. Liquidity pools generate revenue from fixed transaction fees that are used for growing the pool and increasing the value of tokens within it.
That being said, a liquidity pool can’t operate without its users which tells us that counterparties are not entirely eliminated but they have a completely different context than it’s the case with order books.
Having liquidity pools explained in such a simple way, let’s talk about their most common uses now.
Uses of Liquidity Pools
Liquidity pools can be used in a plethora of ways such as for minting synthetic assets, tranching, and yield farming just to name a few.
Yield farming is all about users injecting their cryptos into various pools that are then generating yields for all LPs. The algorithm distributes the tokens, as well as the newly minted ones, in equal shares to LPs.
Tranching makes it possible for LPs to safeguard against potential risks. It refers to a division of digital assets according to calculated risks and allows users and pools to customize return profiles.
You can mint synthetic assets via liquidity pools as well. How do you do that? By adding collateral to a liquidity pool, linking it to a 3rd-party service that provides smart contracts with external information, and then to a preferred asset.
How Does Liquidity Impact the Price of a Token?
Tokens are always traded in pairs (ETH/USDC, DAI/ETH) and the value of tokens traded has to be equal. When removing respective quantities of tokens, you should add the needed quantity of this token’s pair so that removing tokens doesn’t change the value of the pool.
Removing tokens from the pool increases the value of tokens and, needless to say, adding tokens makes their price drop a bit. Also, low-liquidity tokens have higher volatility and vice versa, the ones with high liquidity have low volatility and a higher trading volume.
What is a low liquidity token? That’s a token most crypto traders don’t know about. Low liquidity tokens lack volume and are considered illiquid, which means that it doesn’t have the potential to make big moves in either direction. According to TradeCrypto, the number of providers also impacts a token’s price. The more providers, the greater liquidity of the pool, which makes the price of each token more stable, but also results in fewer shared fees for providers.
Why Are Crypto Liquidity Pools Important?
DEXs were experiencing major crypto liquidity issues prior to liquidity pools. As we already touched upon, liquidity pools and AMMs solved this problem (thus the name), facilitated trades on DEXs, and offered numerous incentives to LPs to deposit their funds directly, which eliminated 3rd-party intermediaries. Needless to say, pools funded with more assets offer better liquidity and more benefits to users.
Not only crypto launchpads (Cryptogeek has crypto launchpads explained simply in this blog) but DEXs as well make it possible to invest in projects and tokens that are still at an early stage.
IDO aka Initial Dex Offering provides a way to get slots for acquiring new tokens. If you’re lucky enough to get a slot, you’ll be able to invest and stake a certain amount of tokens in a pool. In short, you can buy tokens at the lowest price possible and start generating revenue from the liquidity pool before the token goes mainstream.
Is Liquidity Pool Safe?
Liquidity pools are relatively safe. Although there is no middleman, the smart contract that is supposed to keep users’ capital safe can be exploited and everything that you’ve added to the pool can be long gone.
Also, keep in mind that devs know how to modify the smart contract governing rules and take command of your assets. That’s why it is so important to get familiar with highly-liquid pools before locking your digital gold in.
Conclusion
Now that you know how do crypto liquidity pools work, you can start experimenting with different platforms and trading pairs and making a steady income. One thing is for sure DeFi devs are geniuses and we are yet to discover all of the uses and benefits of decentralized finances.
FAQ
- How to choose a liquidity pool?
Choose it based on the coins you hold or want to buy and lock-in. For instance, if you hold Ethereum, you can pick from top liquidity pools such as KeeperDAO. Next, determine your risk tolerance. Riskier pools can help you generate a lot of money, yet, you can also lose all of your staked tokens.
