Liquidity Pool- Work and Risk

Liquidity Pool

Liquidity pools are crypto assets stored to make trading of trading pairs on decentralised exchanges easier. On-chain activity has exploded as a result of Decentralized Finance (DeFi). The volume on DEX can compete with the volume on controlled exchanges in a meaningful way. DeFi protocols are expected to be worth around 15 billion USD by December 2020. New types of items are rapidly entering the ecosystem.

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What is Liquidity Pool

Liquidity pools are pools of tokens held in smart contracts that provide liquidity in decentralised exchanges, attempting to mitigate the problems caused by the illiquidity common in such systems. Liquidity pools are also the name for the intersection of orders that produce price levels that determine whether the asset will continue to move in an uptrend or downtrend if reached.

Automated market maker-based methods are used by the same decentralised exchanges that utilise liquidity pools. The traditional order book is replaced with pre-funded on-chain liquidity pools for both assets of the trading pair on such trading platforms.

Liquidity pools provide the advantage of not requiring a buyer and seller to agree to swap two assets for a defined price, instead of relying on a pre-funded liquidity pool. As long as there is a large enough liquidity pool, trades can take place with minimal slippage, even for the most illiquid trading pairs.

Other users provide the funds in the liquidity pools, and they receive passive income on their deposits via trading fees based on the percentage of the liquidity pool they provide.
The Ethereum-based trading system Bancor was one of the first to create such a mechanism, but it was extensively accepted in the sector when Uniswap popularised it.

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How do Liquidity Pools Work(Liquidity Pool)

AMMs (automated market makers) have altered the game. They’re a key advancement that enables on-chain trading without the use of an order book. Traders can get in and out of positions on token pairs that would be excessively illiquid on order book exchanges because no direct counterparty is required to complete trades.

An order book exchange can be thought of as a peer-to-peer marketplace, with buyers and sellers connected by the order book. Trading on the Binance DEX, for example, is peer-to-peer since trades are made directly between user wallets.
Trading with an AMM is a unique experience. Trading on an AMM can be compared to peer-to-peer trading.

A liquidity pool, as previously stated, is a collection of funds deposited into a smart contract by liquidity providers. On an AMM, you don’t have a counterparty in the classic sense when you execute a deal. Rather, you execute the trade using liquidity from the liquidity pool. There does not need to be a seller at that time for the buyer to buy; all that is required is adequate liquidity in the pool.

On Uniswap, there isn’t a seller on the other side in the traditional sense when you’re buying the latest food coin. Instead, the algorithm that dictates what happens in the pool controls your action. Furthermore, this algorithm determines price based on trades that take place in the pool.

First and foremost, liquidLity must come from somewhere, and anyone can provide liquidity, therefore they could be seen as your counterparty in certain ways. You engage with the contract that governs the pool, which is different from the order book method.

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Earning on Liquidity Pools

AMMs must motivate users to deposit their tokens into pools in order to achieve deep liquidity. Yield farming (also known as liquidity mining) is used in this situation.

Yield farming is a concept in which users receive token rewards in exchange for providing liquidity to AMM pools in order to allow token exchanges. This is akin to depositing fiat money into a bank savings account and earning interest on the assets deposited.

Liquidity providers (LP) are users who deposit their crypto into pools, and the incentives they receive are referred as as LP fees or LP rewards. LPs must deposit an equal amount of both tokens in the pool.

LP incentives are derived from pool swaps and distributed among the LPs in proportion to their shares of the pool’s overall liquidity.

Furthermore, projects that want to promote their coins may give away their tokens to liquidity providers for specific pools. Adding those extra tokens to the usual LP awards might significantly boost a liquidity provider’s overall yearly rewards.

Depending on the protocol, the individual pool, the deposited coins, and overall market conditions, a user’s profit from supplying tokens to a liquidity pool fluctuates dramatically. Some pools have high return rates, but they also have a higher level of volatility and danger.

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Liquidity Pools have Risks(Liquidity Pool)

Impermanent loss is the most typical danger that liquidity providers may face. In layman’s words, impermanent loss refers to the possibility that the fiat worth of a user’s crypto assets invested in a pool will decrease over time.

Impermanent loss occurs when the price of a pool’s tokens changes from when they were deposited, which is organically woven into the AMM idea. The larger the loss, the more profound the shift. Impermanent loss can be minor at times, but it can also be significant.

Pools with at least one stable asset (an asset whose value is linked to a fiat currency, most typically the USD, such as Dai, USDC, or USDT) are less sensitive to impermanent loss because impermanent loss is caused by volatility in a trading pair. Similarly, the danger of temporary loss is lowest for pairs of two stablecoins. In reality, depending on the pool, liquidity provider benefits may be able to cover temporary losses over time.

Smart contract risks are another consideration for liquidity providers. After assets are added to a liquidity pool, they are solely controlled by smart contracts, with no central authority or custodian. As a result, if a bug or other vulnerability is discovered, the coins may be permanently lost.

Users should also be aware of projects in which pool governance is handled solely by the developers, with no community control. There is a risk that the developers will take harmful acts, such as seizing control of a pool’s assets, in such instances.

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Liquidity Pool

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