A Simple Primer on Liquidity Pool

In my last post, I briefly touched upon “liquidity pool” while discussing how decentralized exchanges use them to determine the value of digital assets. Understanding liquidity pools are essential to understand DeFi better. So, in this article, let us delve a little further and see what these pools of liquid are all about.

What is Liquidity?

First, let us discern liquidity. In traditional finance, liquidity refers to the degree to which an asset can be bought or sold in the market at a price that reflects its intrinsic value. Cash or fiat money is the best example of a highly liquid asset. For instance, if you want to purchase a $20,000 vehicle and you have cash, it is easy to buy the car by paying money.  If, instead, you have a painting worth $20,000, would you be able to trade it for the car as conveniently as you could have with cash? Similarly, a stock market’s liquidity is determined by the extent to which it enables the traders to buy or sell stocks or commodities at a stable price. 

Liquidity simply defines how easy it is to exchange one thing for another.

What Is a Liquidity Pool?

Liquidity is a prime indicator of the value of an asset in exchange markets. People are willing to exchange a particular currency, stock, or commodity if they are convinced that they can effortlessly trade them at a moment’s notice. In addition, these assets need to be sufficiently available to manage orders of any amount, big or small.

In the case of cryptocurrencies, especially the new ones, liquidity is an essential element to drive investor confidence. It is vital that the crypto marketplaces trading these tokens have adequate amounts of them. And here is where the liquidity pool comes into the picture.

A liquidity pool can be thought of as a pile of vegetables or fruits in a market. Here, however, traders “pool” a particular token and together maintain enough liquidity of the asset so as to keep investors interested in it. It also ensures the price of that digital currency is relatively stable.

How Does Liquidity Pool Work? 

To begin with, a pool consists of two different tokens, and the first user to deposit the tokens also sets an exchange rate between them, which could even be different from their global market rate. Users, who are called liquidity providers, continue adding the assets in pairs. For instance, in an ETH/DAI pool, for every Ether added, liquidity providers need to put one DAI. The funds in the liquidity pool are locked by using a smart contract. Those who contribute to the liquidity pool receive liquidity provider (LP) tokens by the exchange that they can use to track their contribution. To retrieve their investments, users can “burn” their LP tokens.

Now that we have created a market, it is time to open it up for trade. On the decentralized exchanges, when a deal such as borrowing tokens from the liquidity pool happens, the bourse would charge a transaction fee (% of the deal amount). This commission is then distributed among the pool members proportionate to their contribution. The liquidity providers, thereby, earn a profit.

Are There Risks Involved?

DeFi is not risk-free, and a thorough understanding of how the ecosystem works is critical for investing. There are several risks, including impermanent loss (the change in the price of your tokens from the value when they were deposited in the liquidity pool) and smart contract vulnerabilities (leading to the likes of flash loan attacks). This topic, however, warrants a full-length article, and I will be writing on it shortly.

In short, liquidity pools are pools of tokens aimed at providing liquidity on decentralized exchanges. It is valuable for newly launched assets that are hard to buy and sell. It is a fascinating area that needs to be carefully navigated.

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