What is a Liquidity Pool?

FinanceFeeds Editorial Team

A liquidity pool is a vault into which participants deposit their assets in order to form a market (trading pair) and make it liquid for those wishing to trade in that pair. Technically speaking, the vault is a smart contract that enables users to securely store their tokens.

The liquidity pool is the primary mechanism of a decentralized cryptocurrency exchange (DEX), serving as a substitute for the traditional order books used by centralized exchanges. We will take ETH / BUSD as an example of how the pool operates.

On a centralized exchange, users spot their buy and sell orders and wait for the price to approach the market price, at which point the order is triggered. But what if a trading activity is minimal and the price cannot achieve agreement, or if the amount of orders on one side is not equal to the volume of orders on the other side, and they remain unfulfilled in the pool? This is when market makers enter the picture since they are prepared to boost market liquidity by purchasing/selling a specified quantity of assets.

On the DEX, there is no order book and no “live” market maker. It makes use of the AMM algorithm, which is an autonomous market maker protocol that underpins the liquidity pool’s operation.

What are Automated Market Makers? / AMM

Automated market makers are geared to trade back and forth with other parties. Automated market makers facilitate trades efficiently by bridging the gap between buyers and sellers of tokens so that anyone can purchase or sell tokens without having to go through a lot of trouble such as finding someone else who has those tokens wishing to transfer them. Automated market makers earn profit from trading, charging a small fee for each trade. 

There are basic questions and answers that can help you be a more confident participant in the liquidity pool: 

How do I participate in a liquidity pool? 

To participate in a liquidity pool, you must deposit your assets into it. This can be done using a number of methods, such as MetaMask or offline transactions. 

 What’s stopping me from withdrawing my deposited funds at once? 

There are some safeguards to prevent this from happening. A transaction initiating a withdrawal must be sent to the liquidity pool. If the transaction is not known by the pool, it will not approve any withdrawals. You can be sure that if you are withdrawing something, the person who you are exchanging with has already approved it!

What about my assets?

They are safe. Liquidity pools cannot touch your assets since they only allow trade within what’s deposited in them.

When do I get paid? 

Every time someone else uses your market or trades on it, proportional returns are received into your account via smart contract callbacks/events. This payment comes out of the spread between ask and bid prices of each order placed on your market pair (this is where fee structures come into play).

How do I deposit my own assets? 

There are multiple ways to securely provide your deposited tokens, the most popular of which is MetaMask. Make sure you use a wallet that can sign transactions offline (e.g Parity), only if you wish to transact permanent, irreversible tokens into the liquidity pool.

What fees may be imposed? 

Liquidity pools make their income by imposing fees on their users via an innovative fee structure. The fee structure is completely up to them how they want it (the only requirement is that it is high enough to prevent spam on a given trading pair). The most popular fee structure is a spread between bid and ask orders.

What is the best way to mitigate potential risks?

 The best way to mitigate these risks is by using the service of multiple liquidity pools, in order to cut down on counterparty risk. Also, use decentralized exchanges when possible to have your orders fulfilled inside your specific liquidity pool.

How to find an exchange with the best liquidity provider?

When a liquidity provider provides liquidity to cryptocurrency exchanges, it is called a liquidity solution. These liquidity solutions are made for the purpose of providing high crypto liquidity at exchanges.

To find an exchange with the best crypto liquidity provider, there are a few things that you should keep in mind:

1) Always sort exchanges by 24-hour volume – highest first. This will filter out all small exchanges and show the liquidity condition.

2) Liquidity providers do not work with all exchanges, so there might be exchanges without liquidity solutions. This will dramatically lower liquidity at the exchange and will make it harder to: a) withdraw coins from exchange; b) deposit coins to an exchange. 

3)   Remember liquidity solutions do not always cover all coins. This will also drastically lower liquidity and it might be impossible to withdraw certain coins from the exchange. 

Verdict 

Liquidity pools are a critical component of the technological stack for decentralized finance. Even if this system has its pluses and drawbacks, they enable, among other things, decentralized trade, lending, and profit-sharing. These smart contracts are used in practically every area of decentralized finance and are likely to continue to be popular for a lengthy period of time for their comfortable and smart approach.

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