Liquidity Pool Explained

24 Aug 2022

Liquidity pools can be viewed at their most fundamental level as smart contract-enforced wallets for digital assets.

Decentralized exchanges (DEXs), like the Balancer protocol we're looking at, employ them to provide liquidity for token and cryptocurrency trading.

DEXs use these to offer liquidity for token and cryptocurrency trading.

While early attempts like Bancor introduced the concept of a Liquidity Pool, Uniswap and Balancer made the concept popular. Before diving into the mechanics of liquidity pools, let's examine why they exist.

What is liquidity pool in crypto

Why we need a liquidity pool

You have undoubtedly glanced at the order books of regulated exchanges like Coinbase or Binance if you are acquainted with them (depth of market).

Similar to this, well-known stock exchanges like the Nasdaq and the New York Stock Exchange adhere to a set procedure.

Buyers and sellers negotiate the conditions of their bids and requests face-to-face in this form of the order book.

The objective of a buyer is to pay the least amount of money possible for an item, while the objective of a seller is to make the most amount of money possible from a transaction.

But before such transactions happen, the parties buying and selling must first agree on a price. Either the buyer increases their offer, or the seller decreases their asking price. This is conceivable.

But what if no one will carry out your request at a reasonable cost? What happens if there aren't enough units of the cryptocurrency we wish to purchase? The market makers are starting to move at this point.

Organizations referred to as "market makers" enable transactions between buyers and sellers by consistently announcing a willingness to acquire or sell an item. In other words, they allow consumers to trade anytime they want without waiting for a new counterparty to enter the market.

The primary cause of this is that the order book model largely depends on the existence of one or more market makers who are always prepared to "create a market" for a certain product.

Without market makers, an exchange would rapidly become useless to regular customers due to a lack of liquidity.

Furthermore, market makers often adjust their prices to reflect an item's current worth.

As a result, significantly more orders and cancellations than normal are forwarded to the exchange.

Also See: Most Rewarding LP Program: hi's 200 Million HI Liquidity Program

What does liquidity pool mean in crypto

How it works

Now that we know why liquidity pools are necessary for decentralized finance, we can examine how one works by reviewing the DeFi protocol created by Balancer Labs.

A single liquidity pool consists of two tokens, and each pool makes it possible to launch a new market for a particular token pair.

The DAI/ETH liquidity pool on Balancer is a possible model for other successful pools.

Once the pool is formed, the first liquidity provider to join determines the initial asset price.

There is an incentive for the liquidity provider to contribute both tokens to the pool in an amount that is proportionate to their relative worth.

Suppose the pool's tokens are priced differently than the current price on the global market, which creates an immediate chance for arbitrage. In that case, liquidity providers run the risk of incurring financial losses.

This notion of distributing tokens proportionately applies to any new liquidity providers willing to contribute extra funds to the pool later.

In exchange for providing liquidity to a pool, a liquidity provider (LP) receives LP tokens proportional to all LPs' total amount of liquidity to the pool.

All LP token holders share a fee of up to 0.3% of the entire transaction value whenever the pool is used to make a deal.

Liquidity providers must destroy their LP tokens before they may access the underlying liquidity and recoup any fees that have accrued on them.

Token price changes are made according to a predetermined procedure for trading tokens as they accumulate in a liquidity pool.

This process goes by another name: Automated Market Maker (AMM). Liquidity pools using various protocols may each use a slightly different algorithm to operate.

Balancers' liquidity pools, like most others, utilize an algorithm called a constant product market maker to ensure smooth trading at all times.

This method ensures that if two kinds of tokens are issued, their Sum is always the same. In addition, the algorithm ensures that a pool can always provide liquidity for any size of contract.

The fundamental reason is that the algorithm asymptotically increases the token price whenever the desired quantity increases.

The mathematics behind the constant product market maker is fascinating; nevertheless, I will abstain from explaining it here to save this post from becoming too long.

The key takeaway is that the price is set according to the distribution of tokens in the pool. For instance, buying ETH from a DAI/ETH pool would decrease the available quantity of ETH while increasing the available supply of DAI.

As a result, the value of ETH rises while the value of DAI falls. Price changes are dictated by the transaction volume and are inversely proportional to the group size.

Since the price effect, also called slippage, is proportionate to the amount of the trade and diminishes with increasing pool size, bigger pools may accept larger transactions without adversely impacting the price.

Some protocols, like Balancer itself, have started incentivizing liquidity providers with more tokens to give liquidity to particular groups since a bigger liquidity pool causes less slippage and leads to a better trading experience.

Because greater liquidity pools reduce the need for "slippage," or inefficient trading, in the market, we'll talk more about this phenomenon, known as "mining for liquidity," in a later article.

With the principles of liquidity pools and automated market making, we can eliminate the requirement for a centralized order book and third-party market makers like banks and brokers.

That's because we don't have to depend on institutional traders like banks and brokers to facilitate our market transactions.

Marketplaces, so tokens and digital currencies may be traded and traded and traded all the time.

Also See: 5 Tips on Investing for Beginners in 2022 by Warren Buffett

What is liquidity pool in cryptocurrency

Hi Liquidity Pool

Liquidity may be added in one of two ways.

The ETH/USDC liquidity pool on SushiSwap requires equal quantities of ETH and USDC, which you may sell on any decentralized exchange if you choose to contribute money directly.

Trading ETH for USDC, borrowing DAI against ETH, and most other DeFi operations nearly often involve two-sided transactions, so you'll need a matching pair of tokens. 

Consequently, to maintain a balanced pair, most protocols need liquidity providers to commit the equivalent of two crypto assets (divided 50/50). 

Up to eight tokens may be added to the liquidity pool in a novel technique used by Balancer.

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To Sum it Up

Once the pool is formed, the first liquidity provider to join determines the initial asset price. If the pool's tokens are priced differently than the price at which they are currently trading on the global market, liquidity providers risk losing money.

This notion of distributing tokens proportionately applies to any new liquidity providers willing to contribute extra funds.

Financial Disclaimer

It is important to emphasize that absolutely nothing in this post should be interpreted in any way that it provides investing or financial advice.
The views shared in this article are solely those of the author, and as such, they should not be used as recommendations for financial transactions or investments.
This information is supplied “as is” without accuracy, reliability, or comprehensiveness assurances.
The bitcoin price has recently been subject to erratic swings due to its very volatile character.
Everyone considering investing in a cryptocurrency should research and know their region’s relevant regulations before deciding whether to invest their money into a cryptocurrency.

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Banks and financial institutions should attempt to achieve a liquidity coverage ratio of 3% or more. In most cases, banks will maintain a higher level of capital to give themselves more of a financial cushion
We should always plays a safe game
Is it possible for one to mine from liquidity pools?
In one line we would say, add and remove liquidity
Liquidity in our crypto is very important for respective coins for stay strong in this world
I still ask same question
The concept o liquidity is still yet to be understood by so many people in the crypto space. Thanks for sharing this wonderful article that is well explanatory