1. How do liquidity pools work?
Let’s start from the beginning. Have you ever wondered how the liquidity pools actually work? We think the coins you get from exchanging on Uniswap must come from somewhere. Here the liquidity pools are on the bottom. They form the basis of DeFi, allowing market participants to successfully buy and sell crypto assets and providing the liquidity for withdrawal (or purchase).
Liquidity pools vs. order book formula
If you want a benchmark for liquidity pools, let’s take an example of centralized exchanges: If you buy BTC for USD on Binance, you need the second part of the transaction. Users can place the buy order (which goes into the order book) and when the seller appears (who sells BTC at a price you want), you get crypto and the other side gets fiat.
Liquidity pools allow crypto market participants to trade without having to wait for the counterparty to the transaction, as this role is performed by liquidity providers who have an incentive to “share” their cryptocurrencies as liquidity.
Liquidity pools and automated market makers
Additionally, liquidity pools form the basis of the transaction processing model in the world of decentralized finance. It’s called AMM – Automated Market Maker – which means the entire market making process is now automated.
What is the mechanism behind liquidity pools?
On the one hand, there is the pool provided by the blockchain project itself and filled with liquidity by liquidity providers aka DeFi Farmers, which are simply crypto market participants looking to earn interest on their tokens. On the other hand, we have dealers. Now let’s take an example:
- When a trader wants to make a sell transaction, they rely on the pool of liquidity provided by the blockchain project and DeFi farmers.
- When token A is sold, the amount of A in the pool increases and the amount of B decreases (since the final valuation score is always a 50/50 ratio).
- If token A is bought, there will be fewer A tokens and more B in the pool (the token amount ratio will change, but the value will remain 50/50).
The whole process is automated and regulated by the mathematical algorithm.
Let’s take an example of the Uniswap V3 mechanism. Depth of market is calculated using this formula: m (δ) = 1 s i0X +d(δ) i=i0 λx(i) + p −1 0 λy(i).
Each type of transaction or in-protocol operation has rules that ultimately regulate the token ratio in the pools and ensure the proper functioning of the market. The liquidity provider receives LP tokens representing their share of the pool. LP tokens form the basis for calculating the value of the tokens when the liquidity provider decides to withdraw the assets. Learn more about the mechanism behind LP tokens here.
(If you want to learn more about the mathematical processes, read this document from Uniswap.)
In summary: what are the liquidity pools?
These are tokens locked in a smart contract (called a pool). The total amount is split into two different crypto assets: for example, 50% of the token is paid in USDC and 50% is paid in the token of your protocol. If the initial pool value is set to $300,000, you will need $150,000 USDC and $150,000 in your token.
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