The development of decentralized exchanges arose from the need to interact with crypto assets without permission. Centralized exchanges allowed for a simple user interface and process for crypto trading. In a centralized exchange, liquidity is provided through order books. This is a list of buy and sell orders for an asset placed on the stock exchange. Order books show the price at which traders are willing to exchange cryptocurrencies and how frequently the asset is traded. With this method, liquidity depends on how many traders are available to trade.
How do liquidity pools work in decentralized exchanges?
Decentralized exchanges use liquidity pools, which contain a pool of crypto assets deposited by other crypto users, to provide traders with a marketable market. The users who contribute to the pool’s liquidity are called liquidity providers. The type of decentralized exchange determines how the pool works.
Liquidity pools in Uniswap are created by locking ERC-20 token pairs in a smart contract. These pairs are deposited in the same value. If a user wants to create an ETH/USDT pool and deposit 1 ETH, the USDT should balance the price of Ether. So, the initial deposit can be 1ETH/1000USDT.
Curve Finance is an exchange that provides liquidity for stablecoins based on the Ethereum blockchain. Users add liquidity to existing Curve pools built into the network. There are three types of curve pools: simple pools made up of stablecoins paired against each other (e.g. DAI/USDT), lending pools made up of stablecoins packaged and paired against each other, and metapools made up of pairs consist of stablecoins and an LP token.
This is how you benefit from liquidity pools
After creating a pool or contributing to an existing pool, most liquidity pools reward providers with a Liquidity Provider Token (also called an LP Token). These tokens represent the provider’s contribution to the pool. If the pool contains $1,000 worth of tokens and the provider has added $200 worth of tokens, they will receive 20% of the total LP tokens minted for the pool.
A trading fee is charged for each exchange in the pool. This fee is distributed as a reward to all liquidity providers in the pool according to their LP tokens. The provider with 20% of the LP tokens gets 20% of the trading fee. Vendors can claim these rewards and the assets originally deposited into the pool by burning their LP tokens. Most decentralized exchanges require the tokens that provide liquidity to be locked for 7-12 months.
LP tokens can be connected to lending platforms like Aave and used as collateral for crypto lending. At Curve Finance, users who provide liquidity to the Curve lending pools earn additional interest from the lending platforms to which the tokens are lent.
Nancy J. Allen is a crypto enthusiast and believes cryptocurrencies inspire people to be their own bank and break away from traditional money exchange systems. She is also fascinated with blockchain technology and how it works.
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