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What are crypto liquidity pools and how do they work?

DeFi needs no introduction due to its relevance in the blockchain space. This alternative financial system allows users to leverage their cryptocurrency holdings to huge profits. In addition, it outperforms traditional financial systems in creating value for investors. No wonder this aspect of blockchain is growing and gaining traction with investors, introducing them to many financial use cases – those that already exist and those that are new.

An important factor behind the thriving DeFi ecosystem and its popular applications is the presence of liquidity, which allows users to indulge in all kinds of use cases with ease. While centralized systems incentivize institutions or individuals with large amounts of money to make markets, DeFi allows any user to provide liquidity. In providing liquidity, individual users can expect massive profits unmatched by traditional instruments. This is made possible by so-called liquidity pools, which, in addition to user incentives, are also responsible for the functioning of the entire DeFi ecosystem.

What are liquidity pools?

Liquidity pools are DeFi’s on-chain answer to liquidity delivery, keeping the whole process decentralized, autonomous and affordable. Known as Liquidity Providers (LPs), users stake their crypto coins and tokens in smart contracts to keep assets liquid and are remunerated significantly for doing so.

Liquidity pools are found in AMM DEXs, lending-borrowing protocols, and yield farms that allow users to exchange, borrow, or stake cryptocurrencies. The most popular implementation is often within AMM DEXs, which allow users to exchange the tokens they own for those they want from the pool. Liquidity pools therefore eliminate the need for centralized market makers and order books on DeFi exchange platforms.

How Liquidity Pools Work

The removal of key components found on CEXs makes the workings of DEXs and their underlying liquidity pools extremely interesting. Liquidity pools rely on smart contracts to hold the crypto staked by the user, regulate the prices of the tokens in the pool, and execute trades for the user.

Liquidity pools work like this: LPs put cryptocurrency pairs 50/50 into these pools. Although liquidity pools contain more than two cryptocurrencies in different ratios on certain protocols, the most common pools have the aforementioned configuration. For example, ETH/USDT pools are quite common among the AMM DEXs running on the Ethereum blockchain.

In the pools, the value of liquidity is maintained by algorithms based on supply and demand created by trading activity. These algorithms, known as Automated Market Makers (AMMs), automate processes such as providing liquidity and determining token prices. Thus, liquidity pools can replace centralized order books and on-chain implemented order books that are expensive and cumbersome to operate in crowded networks.

Due to smart contract automation, liquidity pools do not require counterparties to match trades. Order book exchanges work by bringing together different parties who want to sell and buy assets. However, liquidity pool deals are peer-to-contract. In peer-to-contract exchanges, users acquire assets from liquidity pools by escrowing the other asset of the pair in a process known as a swap. Considering the ETH/USDT pools found on Ethereum DEXs, a user wishing to acquire ETH must deposit an equivalent value of USDT into the pool.

LPs provide liquidity in such liquidity pools by putting equal values ​​of both assets in the pair – a $1000 share of ETH would justify 1000 USDT stablecoins. The AMM algorithm keeps the price of the assets relative to each other. As the value of USDT remains stable, the value of ETH in the pool will vary depending on the abundance or scarcity due to the swaps experienced.

With any cryptocurrency exchange, LPs are motivated by the transaction fees charged from users and other rewards depending on the liquidity pool. Transaction fees are awarded to LPs in proportion to their share of the pool. Upon depositing their funds into the liquidity pool, LPs receive LP tokens representing their share of the contribution to the pool. Aside from these LP tokens, which LPs can use to withdraw their contribution from the pool, in some cases they can also be used to earn additional rewards through yield farming. Yield farming contracts allow DeFi participants to stake their LP tokens on a farming contract to earn rewards on top of staking rewards earned from liquidity pools. Yield farming, also known as liquidity mining, provides LP token holders with an incentive to hold their stake in the liquidity pool for longer periods of time.

Despite the potential to generate huge returns, users need to be aware of the risks associated with liquidity pools. From rug pulls and exit scams to market movements and volatility, cryptocurrencies are high-risk investments, especially when betting on profits in DeFi protocols. One of the common risks associated with liquidity pools is temporary loss.

Temporary Loss – A liquidity pool risk

Volatile loss is a phenomenon associated with liquidity pools where users experience a relative loss in value with their wagered assets that would be worth more if they chose not to wager them at all. Such a loss occurs due to market movements when the value of the assets employed rises or falls. Because the value of assets in liquidity pool pairs is relative to one another, larger market moves in the same assets present arbitrage opportunities.

Hence, arbitrage traders take advantage of the price differentials between the same assets that exist in liquidity pools and other markets such as centralized crypto exchanges. The swaps executed by the arbitrage traders leave a disproportionate ratio of tokens in the pool, which often dilutes the number of tokens that have increased in value or increases the number of tokens that have decreased in value. This often leads to a scenario where the total value of the pool at that point is comparatively less than what it would have been if the pool’s users had retained their original investments. Although the value of the user’s share of the pool may be greater than their original stake, they still suffer a comparable loss on paper due to the changing ratios of assets.

This type of loss is known as fickle because it can be recovered when the value of the tokens returns to their original price. It only becomes permanent if the user withdraws their bet at the moment when their investments are negatively affected by market fluctuations. Additionally, the trading commissions and rewards earned from the pool can sometimes make up for their loss. However, it’s still important to be aware of the existence of this phenomenon before users dip their toes into staking liquidity pools.

Liquidity pools keep DeFi applications running

Despite the risks associated with providing liquidity in DeFi, users can earn huge sums from liquidity pools. A thorough understanding of how they work will help users invest their funds more safely while also profiting from them and benefiting the DeFi ecosystem. Currently, liquidity pools account for and will continue to account for a large amount of liquidity flowing through DeFi protocols. Hence, liquidity pools play a very important role in the decentralized world as they enable the functioning of all dApps that need liquidity flowing through them.

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