Liquidity Pools 101
Liquidity pools are core for any decentralized exchanges (DEX), they facilitate the trading of new cryptocurrencies before being listed on any exchanges.
What is a Liquidity Pool?
It is a collection of funds locked in a smart contract on a decentralized finance (DeFi) platform where anyone can deposit their crypto assets and receive rewards in exchange for providing liquidity to the platform.
They are used to facilitate trading by providing liquidity and are extensively used by decentralized exchanges (DEXs).
Bancor was the first to include liquidity pools, but they became widely popular because of the success of Uniswap, a decentralized exchange featuring today in the world's top 20 crypto projects.
Why do we need liquidity pools?
Centralized crypto exchanges like Coinbase, Binance work on an order book model, the same way the Bombay Stock Exchange (BSE), London Stock Exchange (LSE), New York Stock Exchange (NYSE) and NASDAQ work.
In the order book model, buyers and sellers come together and place their orders. Buyers, also known as bidders, try to buy certain assets at a lower price, whereas sellers try to sell their assets for as high as possible.
For trade to happen, both buyers and sellers have to find a middle path on the price. Once they are at the meeting point trading takes place.
What if there are not enough coins to buy? This is where market players come into the picture.
Market makers are entities that facilitate trading and are always willing to buy and sell a particular asset and by doing this they provide liquidity. This helps users to trade and they don't have to wait for the other party to show up.
How does the liquidity pool work?
A single liquidity pool holds two tokens and each token creates a new market for that particular pair of tokens.
Klever is also looking to launch its own liquidity pool in the coming months. Klever is working on creating a liquidity pool. Klever products are already serving over +3 million users across the globe.
Let's understand by an example. DAI/ETH is a good example of a liquidity pool on Uniswap. If you want to start a liquidity pool, a new pool has to be created, in this case, DAI/ETH.
The first liquidity provider (LP) is the one that sets the initial price of the assets in the pool. LP is incentivized to supply an equal volume of both tokens in the pool. This remains the same for all the other liquidity providers that are willing to add more funds to the pool later.
When liquidity is supplied to a pool, the LP receives special tokens called LP tokens in proportion to how much liquidity they have supplied to the pool.
When the trade is facilitated by the pool, a 0.3% fee is proportionally distributed among all the LP token holders. If the liquidity provider wants to get the underline liquidity back, then the LP must burn their LP tokens.
Each token swap that has taken place by their liquidity pool facilitates price adjustments according to the pre-set pricing algorithm.
This mechanism is also called an Automated Market Maker (AMM). However, liquidity pools across different protocols may use slightly different algorithms.
Basic liquidity pools like those used by Uniswap use constant product market maker algorithms that make sure that the product and the quantity of the two supply tokens always remain the same.
Algorithms help pools always provide liquidity
Apart from that, because of the algorithm, a pool always provides liquidity, no matter how large the trade is. The main reason for this is that the algorithm increases the prices of the token if the desired token quantity increases.
If you buy ETH from the DAI/ETH pool, the price of DAI decreases and the price of ETH increases.
The price movement depends on the size of the trade in proportion to the size of the pool. The bigger the pool is in comparison to the trade, the lesser the price impact/slippage.
So large pools can accommodate bigger trades without much movement in the prices, as larger liquidity pools create less slippage and result in a better trading experience.
Some protocols like Balancer have started incentivizing LPs with extra tokens for supplying liquidity to certain pools. This process is called liquidity mining. The concept behind liquidity pools and automated market making is quite simple and extremely powerful.
In this way, we don't have to have a centralized order book anymore and we don't have to rely on external market makers to constantly keep providing liquidity to an exchange.
With liquidity pools, DeFi protocols have exploded in popularity and a large part of the sector's growth is due to the decentralization of liquidity.
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Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific provider, service or offering. It is not a recommendation to trade.