How Do Crypto Liquidity Pools Work?

How Do Crypto Liquidity Pools Work

Liquidity pools enable users to trade in various cryptocurrencies without having to use third-party exchanges. Here’s how they work!

Be it for startups launching Initial DEX Offerings (IDOs) on decentralized exchanges (DEX) or cryptocurrency traders—liquidity pools have become indispensable. Liquidity pools are the virtual places where trading happens and companies make money. Before understanding their mechanism, let’s take a look at what they are.

Understanding liquidity pools

A liquidity pool refers to a pool of tokens that are locked in a smart contract, which is a self-executing program based on the agreements between the buyer and seller. The pool enables cryptocurrency trading by providing users with liquidity.

Liquidity refers to the ease with which a token can be swapped with another. It is essential to the decentralized finance (DeFi) ecosystem, given the numerous cryptocurrencies doing the rounds these days.

How do liquidity pools work?

Liquidity pools form the backbone of DEX by applying the automated market maker (AMM) system. The AMM is a system where investors, or in this case “liquidity providers” (LPs), add equal values of stablecoins and the cryptocurrency’s coins—for example, ETH/USDC—into the pool. This way, people can trade one stablecoin for another by exchanging the same value of Ether for USDC (USD Coins). LPs provide a service to DEX buyers and sellers by equipping them with tokens that are easily tradable within the same blockchain.

Furthermore, LPs are necessary to initiate trading in an environment where there is no seller. That is to say that, if people want to buy certain coins but nobody wants to sell, the LPs don the hat of the seller.

How do LPs earn money?

In exchange for adding tokens into the pool, LPs receive interest in the form of trading fees from the trades people make within the pool. This is also known as liquidity mining. On DeFi company Uniswap’s platform, there’s a fixed transaction fee of 0.3%. Over time, LPs can earn anywhere between 2% and 50% annually through trading in liquidity pools. Some LPs switch between numerous liquidity pools to boost their earnings. This is known as yield farming, where yield is the interest that traders earn from staking crypto assets.

Uses of liquidity pools

Yield farming is one use of liquidity pools. Another is governance, where traders who buy tokens within the pool—for example, BTC/USDT—and pay for the trading fees will have an input in how that liquidity pool is managed. They can vote on whether to increase or decrease fees or to change their protocol.

There are also quite a few use cases for using liquidity pools within startups, where companies use them to secure funding.

Challenges faced by liquidity pools

For one, impermanent loss. Impermanent loss refers to the temporary loss of liquidity pool tokens. This could happen due to a number of factors, like price volatility or hacking. For instance, in the case of a BTC/USDT liquidity pool, if the price of Bitcoin drops by 20%, then LPs get less value back. This is because they’ve lost 20% on each stablecoin deposited into that pool. Therefore, these tokens are no longer equal to their initial value, resulting in a transient loss. Another challenge is issues with smart contracts, such as hacking or bugs. If theft occurs, there is no legal recourse given that the system is decentralized. Then there’s the case of faulty developers that might not create a reliable smart contract or not lock the liquidity pool, thus leaving it vulnerable to attacks.

Locking a liquidity pool is important for a startup to build credibility. It shows that your company has a system in place to protect the pool from being drained out and culminating in a “rug pull” scam. This is why startups should partner with reliable developers when they do a token sale or Initial Coin Offering (ICO) or IDO.

How does liquidity impact the price of a token?

Liquidity pools have a direct correlation with trade prices and their volume, so they influence tokens’ prices as well as trading volumes. Tokens with higher liquidity have a higher trading volume and lower volatility, whereas those with little or no liquidity have higher volatility.

As decentralized platforms continue to grow, liquidity pools are sure to become an integral part of the everyday lexicon of startups and traders. 

Header Image by Flickr

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