A Beginner’s Guide on Liquidity Pools

레딧 작성
작성일 2023.08.09 05:39

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Hey guys, since all the light seems to be shed on CEXs these days, here is a quick guide to grasp the basic of Liquidity Pools on Decentralized Exchanges.

Hope you can learn something from it !

What are Liquidity Pools ?

A Liquidity Pool (LP) is quite literally a pool of funds that are locked in a DeFI project’s smart contract. They are one of the fundamental structures of DeFi. To make it simple, a LP represents what you can trade on a specific Decentralized Exchange (DEX). Every DEX (SushiSwap, UniSwap, Pancake, etc.) needs a LP for a pair (ETH/USDT for example). Those coins and tokens available for trade are owned by liquidity providers and traded with what’s called an Automated Market Maker (AMM) which is a kind of program made by the DEX to regulate the ratio of said pair.Liquidity Pools also allow platforms to offer a lending, where there is only one type of asset in the pool.

What’s the point of Liquidity Providers ?

A Liquidity Provider is simply a user of the smart contract that puts his coins/tokens in the LP. As a reward for doing so, the DEX applies a transaction fee to every trade on said pair, which is the redistributed to the liquidity providers according to the amount they gave.When the pool is made of one single asset, the lending platform rewards the provider with the interest rates, just in the same way.

Why would you want to become a Liquidity Provider ?

The obvious answer is passive income. Depending on the type (Lending or DEX Liquidity Pool) and the assets you’ll want to provide, you can make some good appreciation on your holdings, given the fact you don’t need them soon and believe in the project.Also, most DeFi platforms use an in-house token that is given as an extra reward. They can be quite volatile but overall strengthens the whole DeFi ecosystem.While providing liquidity can be really rewarding in many cases, it also comes with risks.

What are the risks of Liquidity Pools ?

I’ll get more in depth with the DEX Liquidity Pools, because lending’s risk is only related to the price/value of the provided asset.First thing is the fact your funds are locked and you don’t want to play around too much with the liquidity as it can strongly impact the trading price. Small liquidity pools induce what’s called a high Slippage Tolerance, which can cause insane trading fees and thus a rejection from the traders’s perspective. If no one trades with a LP you’re providing to, you’re wasting your time and putting your money at risk with Impermanent Loss (IL).Impermanent Loss is a situation well known by lower market cap providers, and is definitely a situation you want to avoid. It is caused by a major price change of at least one of the assets.

What is Impermanent Loss (IL)?

IL describes the situation where the liquidity ratio is not on par with the actual market value. Since DEX LP are working on their own thanks to AMM, they don’t have an Order Book and only rely on the ratio given by the Liquidity Pool.While big Centralized Exchanges (CEX) work only with Order Books for trading, which means we have a permanently updated price for every asset, Decentralized Exchanges (DEX) only relies on the Liquidity Pool’s ratio that was set up when the Liquidity Providers added their assets. This means that the price of an asset on a DEX can be totally disconnected from its actual value, meaning the assets you provided could be depreciating without any way of correcting it.I fully know I could go further as IL can be way more complicated, adding to the fact I’m not going to talk about arbitrage. Don’t hesitate to add your input in the comments

Conclusion

Liquidity Pools can be an excellent way to make good profits in the DeFi space, but comes with risks that can totally have the opposite effect. This is why I would advise you to learn further about LPs, the platform and assets you plan on using before making any move. This is not a risk-free way of getting rewarded and I couldn’t stress enough on the fact you need to know what you’re doing.