Liquidity Pools (LPs) DeFi platforms are a collection of cryptocurrency assets provided by investors and locked in a smart contract. These assets can be used for decentralized transactions such as lending and trading. The higher the liquidity provided, the faster and more convenient the transactions.
Let’s first define the commonly used terms to better understand this concept:
- liquidity
In cryptocurrency, liquidity is a coin’s ability to be converted into cash or other coins. It’s all about being able to easily access your money or complete a transaction at any time. - Liquidity Provider (LP)
A liquidity provider is an investor that provides funding for smart contracts by depositing cryptocurrencies into the liquidity pool. Anyone can be an LP and this can be a source of passive income. - Automated Market Maker (AMM)
The importance of a market maker on a centralized exchange is its willingness to buy or sell assets at a given price. It ensures liquidity by providing a meeting point between the selling price and the buying price. In a liquidity pool, this function of a traditional market maker is automated and anonymous via the AMM. The AMM is an algorithm that supports asset pricing and is different for each protocol.
How do liquidity pools work?
A liquidity pool is created when an investor bundles at least two tokens and locks them in a smart contract. A new market is then created for that token set. As the first liquidity provider, the investor is granted the privilege of setting the initial price for this liquidity pool.
The following liquidity providers can add liquidity to the pool as an investment.
How do trades in LPs work?
For comparison, let’s talk about Centralized Exchanges (CEx). A CEx uses a traditional order book model, which is a digital list showing the prices and volumes that users are willing to buy or sell. A market maker charges relatively higher fees for settling a transaction.
Decentralized exchanges eliminate this mediation process by using AMMs, the algorithm that sets the price of assets in the pool. The ratio of the tokens in the pool automatically determines the price of the tokens.
The existence of AMMs allows users to trade directly with each other, which is more commonly referred to as “peer-to-peer (P2P) trading”.
What do liquidity providers get?
Liquidity providers receive Liquidity Provider Tokens (LPTs), which are receipts or proof of ownership for their share of the pool. The amount of LPTs received is proportional to the liquidity each provider has provided to the liquidity pool. LPs can earn more by using the LPTs to participate or trade other protocols on the same blockchain.
When a trade occurs in the liquidity pool, a fee is charged for the transaction. The fee charged is distributed proportionally to the LPs based on the amount of liquidity they have added to the pool.
Risks in Liquidity Pools
Liquidity pools come with risks like temporary losses and smart contract failures. A temporary loss is when the value of the asset you have deposited decreases over time. Be wary of temporary losses during extreme volatility or price swings. Although this concept makes this passive income a risky model, keep in mind that it is still a very profitable activity.
Another risk worth noting is smart contract errors, which can put your funds at risk. Your funds in a liquidity pool are controlled by a smart contract without a custodian. If there are any vulnerabilities in this contract, there is a possibility of loss.
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