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How do DeFi Liquidity Pools Work?

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It’s been a while since you’re in crypto, so you’re looking for some information about more advanced features, and here you are, in a liquidity pool, wondering what it is and why one needs it. Meanwhile, it’s quite a hot spot to reveal, as many exchanges want to stay decentralized and faster, easier to operate. 

 

What is a DeFi liquidity pool?

To begin with, let’s find out what liquidity means. It’s an essential thing for a market, which means your asset can be easily converted into fiat money or exchanged for other coins. It helps to reduce an asset's price and make a market more stable with a lower fluctuation in price. The lower the liquidity level is the more volatile asset’s price. The higher liquidity makes volatility lower. That’s pretty much it. 

 

It’s should be noted, though, that the liquidity pool should be created the way empowering crypto providers to stake their assets. Once the liquidity is provided by the users, they are provided with liquidity provider tokens which are known as LP. LP tokens have their own value and can be used in the DeFi ecosystems in different ways. Having 20% of the liquidity pool means that you’ll get 20 LP tokens. They also can be transferred, exchanged, or staked within other protocols. 

 

A liquidity pool is staffed with tokens or other funds and locked in smart contracts. It provides liquidity and facilitates trades between the assets on a DEX, a decentralized exchange platform, in a quicker and more convenient way. The pool has two tokens to create a trading pair. Once a pool’s contract is created, its balance is 0, so a provider seed with a deposit and sets the price. Other providers deposit pair tokens according to the current price. 

 

Another crucial component of any liquidity pool is AMMs, automated market makers. Before them, liquidity was quite a fuss, as the interface was far too complicated, and there were a few buyers and sellers on the market. AMMs solved the problem by creating pools and offering to the user’s liquidity that made people supply pools with their assets without any kind of intermediary. Trading is much easier once the pool has more liquidity. 

 

Who was the first to try to incorporate a liquidity pool? Bancor, but UniSwap obviously did a better job, and now it’s the most popular among users and the largest exchange operating liquidity pool. The following platforms have liquidity pools, too — SushiSwapCurve, and Balancer, Binance Smart Chain (BSC)PancakeSwapBakerySwap, and BurgerSwap.

 

AMM vs Order book

What was before liquidity pools and AMM mechanisms came into existence? Nothing special, just an order book, that still exists and works when we talk about a centralized exchange (although, there are some DEXes working on the order book model, too) where sellers and buyers submit their orders in an order book. An order book shows ranked prices, that help traders to keep track of a level of interest, availability, and a trade’s depth, all that information keeps a market transparent. 

 

AMM, also known as automated market makers, is a base of a decentralized exchange and an alternative for an order book. It allows pools to stay liquid 24/7. Users provide the liquidity and earn some regular passive income for that. As we know, a liquidity pool is a shared source of tokens, and users supply the pool with their own tokens becoming liquidity providers. 

 

Liquidity pool risks

 

Even though now we embrace the concept and understand the basics, we shouldn’t forget about risks that could appear on the horizon.  Here they are:

1. Impermanent loss

That could happen if you are a liquidity provider, a person who shares his/her assets with a liquidity pool. In two words, your deposited assets changed their price and now it differs from the starting point, so you lost some money. The bigger this change is, the bigger your loss. But good news, thanks to the trading fees, the loss could be reduced or equalized. 

It’s believed that the best thing a provider can do is to invest in a stable coin, as it’s not that volatile compared to other cryptocurrencies.  

2. Rug Pools

To put it simply, it’s a new type of scam when a new altcoin is listed on the exchange platform and then paired with a popular, well-known coin or token such as Ether, Tether, Bitcoin,  etc. Then, those worthless altcoins are hugely promoted for selling to a customer. Customers swap their assets for the fake, hastily created ones, and in the end, they lose everything with no opportunity to return their loss. 

3. Smart contracts risks

As the pools are placed in smart contracts and governed by them, there is a slight possibility of being hacked due to some accidental bugs in their codes.

 

Best 5 DeFi liquidity pools providers 2021

It’s a decentralized platform that allows you to exchange Ether (ETH) for any ERC-20 token. The platform runs an exchange where you can create a trading pair. The fee for those who will swap their assets is 0.30%, and it’s shared with the providers of liquidity. 

Once you’re a provider, you deposit your crypto and get an equivalent amount of Uniswap tokens. 

It’s a serious platform providing you with more than 300+ tools including advanced ones, and competitive turnover fees. Their pool offers pairs with 7 digital assets: Bitcoin (BTC), Ethereum (ETH), Litecoin (LTC), Ripple (XPR), DASH (DASH), EOS (EOS), and Stellar (XLM).  All the operations are smooth and really fast and executed automatically, that’s one of the strongest network’s features. 

The platform is built on Ethereum and it’s a portfolio manager, liquidity provider, and price sensor. They offer a wide range of pools —private, shared, and smart ones. Balancer pool can be created with two and up to 8 ERC20 tokens at a time. You can also mine with Balancer their native token called BAL. 

This is another decentralized exchange proving a pool. Among their pros are the following: low fees, low slippage, and low risks. It’s extremely simple to start trading and swapping there, so if you’re a newcomer you shouldn't have any problems with how to begin. 

The network enables you to have highly safe and quick token swapping. The transaction fees are comparatively low, they are about 0.30% for joining a liquidity pool, and they mostly go to liquidity providers. They also have a reward program with their own token called SUSHI, which goes to providers who support the pool. SUSHi could be earned without a stop even if the liquidity pool has a lack of crypto, and that’s quite innovative. 

 

Closing thoughts

Thanks to liquidity pools exchanges could stay decentralized and easier to manage. The concept embodies a blockchain idea itself — no middlemen between a buyer and a seller, everything is automated and makes the process of trading quicker and easier. It’s an essential part of the DeFi ecosystem, especially of decentralized exchanges, DEXs, that can be used for different purposes. 

Don’t forget to check on the pools, for that reason you can use this website, read the latest news and reviews and never forget that trading and investing is not only about gaining profit but also about some risks, as well. 

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