What is a liquidity pool?
Liquidity pool is basically a pool of crypto tokens put together and kept safe in one smart contract to enable decentralized trading. They exist primarily in AMM DEXes (decentralized exchange); After that, however, they were also used by other decentralized applications such as lending & borrowing products.
The majority of liquidity pools consist of a pair of cryptocurrencies, allowing trading between the two directly. Despite this, later decentralized exchanges like equalizer have proven that liquidity pools do not necessarily have to consist of only two cryptocurrencies: With their innovation, up to 8 tokens can be flexibly added and traded within a single liquidity pool.
Liquidity pools are first defined and used in AMM DEXes, started with Bancor and popularized by Uniswap. Liquidity pools enable the use of AMM (Automated Market Maker), which facilitates decentralized trading with numerous advantages over the traditional approach.
Liquidity pools mostly consist of a pair of cryptocurrencies
How do liquidity pools work?
Before we get into how liquidity pools work, let’s first take a look at the original method of trading: via order books.
Order books consist mainly of 2 participants: doers and takers
- Maker: Those who place the order.
- Customer: Those who take the order.
Order books work similarly to negotiations: manufacturers set an affordable price for their buy/sell orders, and buyers are willing to pay such a price for those orders.
The path of the order books themselves is flawed: it is difficult to complete an order. There are several reasons for this, namely manufacturers and buyers cannot agree on a common price or there are not enough assets available for sale (lack of liquidity).
Therefore, order books almost always include market makers – third parties who are always ready to place buy/sell orders at specific prices for others to accept. In other words, they provide liquidity to a market.
This brings with it some problems, the biggest of which are centralized, meaning they cannot function DeFi. To enable decentralized trading, a different approach is necessary. This is where liquidity pools come into play.
Order books vs. liquidity pools
AMM automates the trading process by eliminating the involvement of market makers. For AMM to work, the liquidity pool is the key factor.
Instead of market makers, AMM incentivizes users to become liquidity providers. This can be anyone, including the traders themselves. Liquidity providers offer liquidity to a liquidity pool in exchange for trading fees and earning agricultural rewards.
As mentioned above, liquidity pools are usually pools containing a pair of tokens. Liquidity providers add liquidity by depositing both in a predefined ratio. The ratio is based on the price correlation between these 2 tokens.
For example, 1 ETH equals 2,000 USDC. In order to provide liquidity to this ETH-USDC liquidity pool, one needs to deposit both ETH and USDC with an ETH-USDC ratio of 1:2,000. If the price of ETH changes, the ratio of the two tokens in the pool will be adjusted accordingly.
Advantages and disadvantages of the liquidity pool
The liquidity pool is a game-changing innovation in the DeFi space. Although it has brought tremendous evolutionary changes to crypto, it is still very flawed and requires improvement.
Advantages
- Enable decentralized trading, eliminating third-party involvement.
- Enable liquid markets without spending a lot of time and money.
- Offer numerous financial applications to make profits.
Disadvantages
- May cause slippage/price impact if liquidity pool is small.
- Ease of access and creation pave the way for rogue projects to profit with low risk and low cost.
- Liquidity providers can suffer huge losses while farming due to rewards impermanent loss (IL).
- Incentives for liquidity providers are still unsustainable, making it difficult to scale liquidity.
How to become a liquidity provider
You can become a liquidity provider at any AMM DEX in the market. i will take SushiSwap as an an example.
Go to their website first Here and connect to your wallet.
Point to “Liquidity” and click “Add to”.
Here you can select the token pair you wish to provide liquidity to, approve it for use by SushiSwap and then add liquidity.
Learn more: How to use SushiSwap
Why are liquidity pools important?
Liquidity pools are important as they are the core component of any AMM DEX. Liquidity is the blood of any market and liquidity pools are the ones who provide that liquidity. Without liquidity pools, AMM-DEXes cannot function and DeFi becomes unusable in general.
Liquidity Pool FAQs
Are liquidity pools safe?
The security of liquidity pools depends on the smart contract behind it. As mentioned above, liquidity pools are pools of crypto tokens that are assembled and kept secure in a smart contract.
Smart contracts can contain insecure features that are beneficial to crypto scammers as they can hijack all of the liquidity in these pools. Before interacting with or using a liquidity pool, make sure the product you are using is safe and secure and the smart contracts are fully audited.
You can use This website to check the security of a smart contract.
How to create a liquidity pool
You can create a liquidity pool on any permissionless AMM DEX like Uniswap or SushiSwap. The process is similar to adding liquidity as described above. Creating a liquidity pool means that you provide liquidity to a token pair that does not already have a liquidity pool.
Simply select the token pair you want to create a liquidity pool for and add liquidity to that pair. If a token is not yet available on this DEX, add the token manually by pasting its address in the search bar.
Yield farming vs. liquidity pool
As already mentioned, yield farming is an incentive that the AMM DEX creates to incentivize the provision of liquidity. When you provide liquidity to a liquidity pool, not only do you receive a portion of the pool’s trading fees, but you also get permission to farm and earn additional rewards.
Farming on SushiSwap
Diploma
Liquidity pools are basically pools of crypto tokens assembled in a smart contract and kept secure to enable decentralized trading. They mainly exist in AMM DEXes (Decentralized Exchanges); After that, however, they were also used by other decentralized applications such as lending & borrowing products.
The liquidity pool is a game-changing innovation in the DeFi space. Although it has brought tremendous evolutionary changes to crypto, it is still very flawed and requires improvement.
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