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If you’ve spent any amount of time in the DeFi space, you may have heard of a liquidity pool. These pools are often promoted as a way to earn passive income with crypto or as a means to earn certain rewards.
Before you jump into depositing your assets into one of the many LP protocols out there, it’s important to know the fundamentals. LPs are an essential technology in the decentralized finance ecosystem that is worth learning about.
This guide will explore what a liquidity pool is, how it works, and why it’s important. We’ll also look into the concept of impermanent loss and how you can prevent it as a crypto investor.
What is a liquidity pool?
Liquidity pools are essentially smart contracts that allow users to exchange crypto without the need for centralized market makers.
Centralized exchanges use an order book system, which keeps a record of buy and sell orders. The problem with the order book system is that they require intermediary infrastructure to match orders, which provides an additional layer of complexity.
Order books are also not an ideal system where anyone can create their own tokens. Order books also become difficult to use when the trading volumes are low.
Rather than use the buy and sell order book system, liquidity pools use automated market makers to determine prices when trading. There is essentially an algorithm that determines the price, rather than the sellers and buyers.
Liquidity pools, as the name implies, give exchanges liquidity. Liquidity is essentially the ability for a coin to be exchanged into fiat or other cryptocurrencies. But why exactly is liquidity important?
Why are they important?
Without liquidity pools, DeFi would simply not be possible.
High liquidity is an ideal situation for many cryptocurrencies. If tokens are available, liquidity stabilizes the market price and lowers the volatility of the asset. When a large amount of a certain token is being traded in a liquidity pool, the automated pricing differences may become negligible.
Low liquidity leads to high slippage. Slippage refers to the difference between the expected price of an asset and the price the user pays upon executing the transaction.
Not only that, a lack of liquidity means that it would be difficult to sell a certain asset. This is certainly the case for new tokens which have just been released to the public.
In order for new projects to work well with the current DeFi ecosystem, developers have to make sure that the protocol incentivizes liquidity so that the tokens can be sufficiently circulated.
How do they work?
Let’s look into how an automated market maker works.
The AMM model uses an algorithm that sets the token prices based on the current ratio of tokens supplied. For example, Uniswap uses the constant product formula x * y = k for its liquidity pool trading pairs.
What this means is that the price of x and the price of y are adjusted so that the total value of the pool remains a constant k.
For example, let’s say that we have a USDC/ETH pair with 1 ETH worth $1000. Let’s assume that the liquidity pool has 10 ETH and 10,000 USDC. Our constant k will be equal to 10 * 10,000 = 100,000.
If someone were to buy 1 ETH from the pool, the value of ETH will increase and the value of USDC will decrease in such a way that k remains constant.
Yield Farming
Yield farming is a popular method of creating passive income from your crypto assets. This refers to the process of lending your money to a liquidity pool in order to receive rewards.
Liquidity pool protocols give out rewards or “yield” to incentivize people to provide liquidity.
For example, you can provide a certain amount of liquidity to an LP with a USDT/BNB token pair. Users who buy and sell tokens from the LP pay a fixed fee. This fee is then distributed as rewards to liquidity providers.
The actual distribution of these rewards depends on the protocol, but it is often based on the amount of liquidity you provide. The more crypto you deposit, the higher your yield.
There are many websites that allow you to yield farm. Curve Finance is a popular protocol because it focuses on stablecoin swapping, which is far less volatile than other trading pairs. Another popular protocol is Compound Finance, which allows you to lend and borrow assets through its platform.
Impermanent Loss
Before you deposit your crypto in a liquidity pool, you must understand the risk of impermanent loss.
To put it simply, the impermanent loss is the amount of money you could have made if you had simply held your money rather than depositing it into a liquidity pool.
How does this happen?
For example, let’s imagine that we have a USDC/ETH liquidity pool with an equal ratio of each token, with 1 ETH worth $100. As a liquidity provider, you add 1 ETH and 100 USDC to the liquidity pool. The dollar amount during the deposit is worth $200 total.
Suppose there are 10 ETH and 1,000 USDC in the liquidity pool. Since the price of each asset in the pool depends on the ratios of their liquidity pools, their prices are separate from prices seen in exchanges.
Let’s say that the price of Ethereum doubles in the next six months, meaning each ETH is now worth $200. To keep the 50/50 ratio, there should be about 7.071 ETH and 1,414.21 USDC.
If you withdraw now, you are entitled to receive 0.7071 ETH and 141.42 USDC, which is about $282. However, if you simply held on to your ETH, you would have $300 worth of tokens ($100 of USDC and $200 of ETH).
The difference of $18 is known as the amount of impermanent loss you have.
There are a few ways to avoid impermanent loss. First, you can focus on stablecoin pairs, such as USDT/USDC. You may not get huge rewards possible from more volatile pairs, but you still get assured income from your share of the trading fees.
Second, you can find liquidity pools that support uneven asset ratios. These include flexible pools that have ratios such as 95/5 and 60/40.
Conclusion
Liquidity pools are one of the most significant concepts in the DeFi space. Without LPs, we wouldn’t be able to implement decentralized exchanges, lending, and other financial contracts.
Crypto investors can take advantage of liquidity pools to make passive money with the cryptocurrency they may already have.
Before investing in a liquidity pool, investors should research how much risk they’ll expose themselves to and whether the risk is worth the rewards they can yield.
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