Liquidity pools: what they are and how they work

Liquidity pools are the formula that allows the exchange of cryptocurrencies on decentralized platforms, where no intermediaries or professionals who adjust prices intervene.

In this article, I will show you how cryptocurrency liquidity pools work, their role in the crypto ecosystem, their advantages to users, and the risks to keep in mind.

What are liquidity pools?

Liquidity pools are a reserve of tokens locked in a particular platform. Users have contributed these funds so that this platform can develop decentralized finance (DeFi) functions, mainly exchanging or swapping cryptocurrencies.

By liquidity, we mean the availability of a particular financial asset. Thus, liquidity pools serve to facilitate trading.

Usually, for the exchange of any asset, the intervention of a market maker is necessary. Market makers are a group of financial institutions that promote liquidity and ensure the proper functioning of the market.

However, DeFi protocols are characterized by no intermediary or central authority being involved. Users interact directly with each other and exchange financial services through smart contracts. In this way, an automated market is created.

A decentralized cryptocurrency exchange (DEX) platform works through an algorithm called Automated Market Maker (AMM). It is an automatic market maker based on a smart contract.

But for the DEX to work, it must be the users themselves who provide liquidity. For this reason, liquidity pools are created.

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How does a liquidity pool work?

Any user can become a liquidity provider in a DEX. It is simple enough that you have cryptographic assets and lock them in the protocol through a smart contract.

However, each liquidity pool comprises two types of cryptocurrencies, which make up a pair for exchange between them. For example, ETH/BTC (Ethereum and Bitcoin).

The user who intends to become a liquidity provider of this pair of cryptocurrencies must contribute to the pool of the two cryptocurrencies in an equivalent amount.

If, for example, 1 Bitcoin is exchanged for 10 Ethers, the user can contribute these amounts, multiples or fractions of them. The important thing is that an equivalence ratio of 50/50 between one asset and the other is maintained when contributing funds to a liquidity pool. Otherwise, the protocol will indicate an error, and we cannot carry out the operation.

In this way, any other user can exchange Bitcoins for Ethers. The AMM will adjust the exchange rate depending on the supply and demand of the pair’s cryptocurrencies.

If there was no liquidity pool for a particular pair of tokens, the exchange between them could not occur in the DEX. Similarly, the more liquidity a cryptocurrency pair has on an exchange, the lower the price slippage.

Why provide liquidity to a pool?

Users who lock their assets into a liquidity pool get a return. It is a passive income generation strategy with cryptocurrencies called “yield farming”.

Traders or users who make cryptocurrency exchanges on DEXs must pay a commission, and a part of it goes to the liquidity providers that make such an exchange possible.

Moreover, some DEXs, when blocking cryptocurrencies in a liquidity pool, offer you a unique token (usually with the denomination “LP” of Liquidity Provider), and you can stake with it to obtain other rewards (in the form of native tokens of the platform or other cryptographic assets). This is known as “liquidity mining”.

What are the risks of liquidity pools?

In principle, any user can withdraw their assets from the liquidity pool whenever they want. However, every time a swap of cryptocurrencies or tokens occurs in a DEX, the supply of one of them increases while the supply of the other asset of the pair decreases. That is why the Automated Market Maker adjusts the price.

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In this way, at the time of withdrawal, the protocol does not return the same proportion of tokens the liquidity provider provided in its day (50/50). Different percentages are obtained depending on how supply and demand have behaved.

The problem is that the value of tokens fluctuates over time. Therefore, you can get a more significant amount of an asset that has fallen in price while you get a smaller amount of tokens than the one that has been appreciated.

The result can be an economic loss compared to simply holding the assets. This risk is called the “impermanent loss”.

For this reason, in addition to the technical risks that may exist, it is necessary to calculate whether the rewards obtained cover the possible loss of value of the tokens received when cryptos are withdrawn from liquidity pools.

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