What is Liquidity Pool? How Important is a Reliable Liquidity Provider

03 Nov What is Liquidity Pool? How Important is a Reliable Liquidity Provider

Because trading activity can change the price and asset quantity, the asset ratio upon withdrawal will likely differ from what was initially deposited. The first liquidity provider usually supplies two assets of equivalent worth in USD into the pool. Impermanent loss occurs when the price ratio of pooled assets fluctuates. For this reason, liquidity mining cannot always provide a stable income for liquidity providers. Nonetheless, users can use the previous earnings from transaction fees and LP token staking to cover the losses.

The exact amount will depend on the size of the pool, the trading activity, and the fees that are charged. Liquidity in DeFi is typically expressed in terms of “total value locked,” which measures how much crypto is entrusted into protocols. As of March 2023, the TVL in all of DeFi was $50 billion, according to metrics site DeFi Llama. Here is an example of how that works, with a trader investing $20,000 in a BTC-USDT liquidity pool using SushiSwap.

With liquidity pools, buyers do not have to be connected to a seller, because liquidity is kept constant through a preset algorithm. Despite the benefits, market movement can work against liquidity providers, because the asset ratio will be different than when it was originally invested, potentially causing losses. Nevertheless, liquidity pools are easy to use as users only need to stake the paired token to receive returns. Liquidity pools are created when users (called liquidity providers) deposit their digital assets into a smart contract.

You could think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book. For example, trading on Binance DEX is peer-to-peer since trades happen directly between user wallets. A liquidity pool is https://www.xcritical.in/ basically funds thrown together in a big digital pile. But what can you do with this pile in a permissionless environment, where anyone can add liquidity to it? This marks the second time Binance has eliminated liquidity pools this month.

The main reason for this is the fact that the order book model relies heavily on having a market maker or multiple market makers willing to always “make the market” in a certain asset. Without market makers, an exchange becomes instantly illiquid and it’s pretty much unusable for normal users. SushiSwap (SUSHI) and Uniswap are common DeFi exchanges that use liquidity pools https://www.xcritical.in/blog/what-is-crypto-liquidity-and-how-to-find-liquidity-provider/ on the Ethereum network containing ERC-20 tokens. As you can see in the above image, Compound has a DAI token liquidity pool. Anyone who wants to lend his DAI tokens can deposit his tokens through the protocol into the DAI pool. In this case, the lender would not communicate with the borrower, but this transaction will happen between the lender and the smart contract.

Investors can sometimes stake LP tokens on other protocols to generate even more yields. Curve pools, by implementing a slightly different algorithm, are able to offer lower fees and lower slippage when exchanging these tokens. In essence, market makers are entities that facilitate trading by always willing to buy or sell a particular asset. By doing that they provide liquidity, so the users can always trade and they don’t have to wait for another counterparty to show up. This means it’s the middle point between what sellers are willing to sell the asset for and the price at which buyers are willing to purchase it.

In this article, we define liquidity pools and explain their importance in DeFi beyond just a lucrative opportunity. Also, be wary of projects where the developers have permission to change the rules governing the pool. Sometimes, developers can have an admin key or some other privileged access within the smart contract code.

If the liquidity provider fails to do so, an arbitrage opportunity is created, leading to a loss of capital. 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. If you’re looking up what a DeFi liquidity pool is, chances are you’re deep in a decentralized finance rabbit hole. Maybe you’ve played with DeFi products like Uniswap and Aave, and perhaps even yield farming. Liquidity pools act as the backbone of the DeFi protocol’s crucial activities.

The Unexpected Value of Crypto Liquidity Pools

However, we cannot ignore the possible risk exposure of liquidity pools. When a trader exchanges his tokens on Uniswap, he will give a fee to Uniswap, which is then distributed to the Liquidity Pool. For more information on Uniswap, you can read our Beginner’s guide to Uniswap.

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• As discussed, liquidity providers get tokens (LPTs) when they provide liquidity.
• If the liquidity provider fails to do so, an arbitrage opportunity is created, leading to a loss of capital.
• These tokens are used to initiate cryptocurrency trading by liquidating them.

Problems may occur when no party is willing to place their orders at a fair price level. This makes trading difficult because it takes both parties to reach an agreement before a trade can be made. Each token swap that a liquidity pool facilitates results in a price adjustment according to a deterministic pricing algorithm. This mechanism is also called an automated market maker (AMM) and liquidity pools across different protocols may use a slightly different algorithm. Trades with liquidity pool programs like Uniswap don’t require matching the expected price and the executed price.

When a new pool is created, the first liquidity provider is the one that sets the initial price of the assets in the pool. The liquidity provider is incentivised to supply an equal value of both tokens to the pool. This concept of supplying tokens in a correct ratio remains the same for all the other liquidity providers that are willing to add more funds to the pool later.

Liquidity pool meaning

Your actual dollar APR can be more or less depending on the value of the token. In other words, in the face of highly efficient exchanges, an exchange without liquidity sucks– and DEX developers planned for this. It provides support to many pooling options like shared, private and smart pools.

What Are Liquidity Pools in DeFi and How Do They Work?

For every pool created, the first provider provides the initial price of available assets in the pool. This initial liquidity provider sets an equal value of both tokens to the pool. Most liquidity pools also provide LP tokens, a sort of receipt, which can later be exchanged for rewards from the pool—proportionate to the liquidity provided.