home” be » Binance Liquidity Pools Explained – How Do LPs Work on Binance?
Liquidity pools are one of the wonders of the crypto age. They are simple enough for a child to understand, yet so effective they supersede hundreds of years of traditional trading practices.
Let’s take a look at one of crypto’s most influential innovations and what’s behind the liquidity pool buzzwords.
What is a liquidity pool?
It’s a lot of crypto assets all thrown together in one big pot. But for what? Traditional centralized exchanges have to offer a buyer or seller when a client wants to make a trade. There won’t always be another trader waiting to sell the asset they want to buy, so the market makers step in and execute the trade on behalf of the exchange. Market makers hold large amounts of assets to ensure trades happen. They provide “liquidity”.
A liquidity pool is different. The large pool of assets stored in it guarantees that there is always a trade available without any person or company fulfilling the role of market maker. It is known as AMM, Automatic Market Maker. This is a key innovation for decentralized (DeFi) applications, freeing them from the need for centralized companies or individuals to enable the market.
The market-making industry is shady at best, and in many cases downright corrupt — more on that later.
Liquidity pools vs. order books
So what are the advantages of LPs over traditional order books? Aside from the decentralization opportunities, the AMM will not cheat. There is a lot of money to be made as a market maker, so much so that market makers pay exchanges billions of dollars for the business. Selling trades to market makers is called Payment For Order Flow (PFOF) and was devised by the notorious Bernie Madoff to let other traders come first.
Simply put, the trading data is used by millions of users to “advance” the profitable trades and make a small profit. According to the SEC, it’s illegal for stocks and securities markets, but crypto exchanges are still unregulated, so not banned yet. It’s immoral, but not illegal. An AMM does not do this. It follows its rules as established at its inception or as decided by the pool’s investors. It’s auditable and transparent, so you don’t have to trust the behavior of sociopathic financial engineers.
The best part is that the profits from a liquidity pool are earned by the pool investors, not the nefarious market-making firms. Of course, the exchange takes its share of the trading fees, but it opens up the business to ordinary retail investors. You no longer need to be a Wall Street insider to profit from stock market trading.
What’s the catch? If you manage to avoid carpet moves, scams, and centralized fake DeFi projects, there is still inherent risk with the AMM liquidity pool model. The price and proportions of the pool’s assets can fluctuate widely, throwing the balancing mechanism off balance.
As a trader, this is the risk that a large trade will interfere with the need to rebalance the pool. The automatic adjustment has a negative effect on the offered price – this effect is called slippage.
As a liquidity provider, the risk is a sunk opportunity cost, which has been mislabeled as ‘impermanent loss’. More on these topics later.
How do liquidity pools work?
The simplest form of a liquidity pool has 2 assets in fixed proportions, for example SOL and BNB. People exchange their SOL for BNB or their BNB for SOL. As long as there is enough of both assets to cover the trades, everything is fine. When a trade is made, the algorithm automatically adjusts the price of each asset to maintain the value ratio of the two assets in the pool.
There are variations with more than two assets in a pool and more advanced math to “smooth” rebalancing and reduce slippage. Some liquidity pools automatically buy cryptocurrency on the open market to rebalance assets, earning trading fees in the process.
They work for the retail investor by providing a vehicle in which to invest your tokens. You can earn a return while your assets are busy appreciating. You rent your crypto to an exchange for which you make a profit.
How to join Binance liquidity pools?
Binance account holders are invited to invest their cryptocurrencies in different types of liquidity pools. The most common is the Binance Swap Pool. Select the pool containing your target cryptos and click on the Liquidity button in the right column. The staking window shows everything we need to do to get started.
After choosing the BUSF/ETH pool, I could choose how much to invest. Binance pools allow us to invest one or both cryptocurrencies in the pool, but you pay a 0.2% fee if you only invest in one of the two cryptocurrencies. Once we’ve selected how much of each asset we want to stake, we can see the projected return and our position in the pool.
You can see the current pool size and how much of each asset is in the pool. Your fees, if any, are shown along with the portion of the pool you own. Next, you see the current slippage rates and annualized return based on price action over the past 24 hours. You agree to the terms and conditions and click on “Add Liquidity”.
To remove your crypto from a liquidity pool, simply click “Remove” in the top left corner of the staking window and follow the on-screen instructions. It’s all very intuitive and requires no prior knowledge or experience.
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Different types of liquidity pools
Binance offers mining pools, locked staking and savings programs. Either way, you can use your crypto to earn an income from all of the pool’s activity. They all have their risks and benefits, but generally you will get the greatest return from using tokens that people are most comfortable trading or borrowing.
The greatest risks come from the most volatile cryptocurrencies. The most stable returns come from stablecoins. Suggested returns are estimates only and are subject to radical change depending on market conditions.
The Risks of Liquidity Pools
As a trader, the risks pay more than the market price for your crypto. This price slide is caused when one of the assets in the pool is trading a lot more than the other. This is less of an issue in the larger pools and would not affect the average retailer on Binance.
It only becomes problematic with the more exotic, less well-financed liquidity pools. There is a slippage level warning whenever you make a trade, so it shouldn’t surprise you.
Ephemeral Loss
From an investor perspective, things are a lot riskier. When you come to remove your liquidity from a pool, you can get a shock. If the underlying assets are radically different in price compared to your investment, you will receive fewer tokens than you wagered. The total dollar value will be the same and the claim is that you haven’t lost overall.
What you have lost is the opportunity to make a profit on the assets wagered. This loss feels pretty permanent to me! I think the name “Perishable Loss” is misleading, especially for those of us who don’t report our wealth in US dollars.
Final Thoughts
Simple but ingenious – the AMA concept has enabled an entire field of research and innovation in finance. It is a disruptive technology that perpetuates the ideology of decentralized finance. It is transparent, fair, honest and incorruptible when done right. Liquidity pools democratize the lucrative stock exchange business.
Of course there are the scammers, as Mark Cuban found at his own expense when staking a bunch of crypto in Titan on Iron Finance. There are also pools that claim to be decentralized but are in fact managed by a specific company. While not decentralized, Binance is a name you can trust. So if you want to participate in a secure liquidity pool, they are one of the best options. Again, note that your transactions will all be recorded and made available to the IRS and law enforcement agencies.
Please read some of the articles we have written about Binance:
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CaptainAltcoin’s authors and guest contributors may or may not have a vested interest in any of the projects and companies mentioned. None of the content on CaptainAltcoin is investment advice or a substitute for advice from a certified financial planner. The views expressed in this article are those of the author and do not necessarily reflect the official policy or position of CaptainAltcoin.com
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