Understanding “Liquidity Pools” in just 3 minutes

Originally, crypto market liquidity has always been a challenge for DEXs (decentralized exchanges) on Ethereum. These DEXs were new technology with a complex interface and a reduced number of buyers and sellers. It therefore seemed difficult to find enough people willing to negotiate and make regular transactions.

The appearance of automated market makers (AMM) has made it possible to resolve this difficulty by creating liquidity pools without the need for third-party intermediaries. But what should be understood behind this “liquidity pool” mechanism?

What are liquidity pools?

Liquidity pools are liquidity reserves that play a key role in decentralized finance. Indeed, they provide the liquidity, speed, and convenience that the DeFi ecosystem needs to function optimally.

This mechanism allows users to pool their assets into DEX-like smart contracts to buy and sell cryptocurrencies without going through a centralized market maker. The advantage of this pool system is that the fees are known in advance and this market is open to everyone.

There are therefore mainly two players in these liquidity pools:

  • Those who provide liquidity. They deposit tokens in the pool for a certain period of time, for a fee.
  • Those who use cash. They take advantage of the liquidity present to operate on the cryptocurrency market: loans, staking…

How do liquidity pools work?

When a user wants to buy a token on a DEX, he does not need a seller in front to carry out the transaction. There is no longer any need here to worry about an order book to manage exchanges between buyer/seller. It is an algorithm (AMM) itself which manages the whole transaction according to the liquidity present in the pool.

Any user can become a liquidity provider (LP) within a pool. In this scenario, the liquidity provider will receive special tokens (so-called LP tokens) in proportion to the amount of liquidity it has provided to the pool. So, when a transaction is facilitated by the pool, a commission is distributed proportionally among all the holders of these LP tokens. Be aware, however, that if the liquidity provider wants to recover its underlying liquidity, plus accrued fees, it will need to burn its LP tokens.

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Advantages and disadvantages of liquidity pools

The main advantages of liquidity pools are:

  • To enjoy a large supply for traders who want to use DEXs. This has made decentralized trading much more efficient and accessible.
  • Offer a new return lever for an investor. Different protocols like Uniswap or Yearn.Finance reward liquidity providers with tokens.
  • The returns from these pools can be very high.

Among the disadvantages, we can mention in particular:

  • A risk called “impermanent loss”. That is to say that in some cases, the LP will earn significantly less than it should have harvested. Indeed, the more there is a difference between the price of the token of the deposit and the current price, the more the investor is exposed to these losses.
  • A risk of hacking or embezzlement with fake protocols.
  • Funds must first be held in a portfolio to participate in a liquidity pool.

Conclusion: A very fashionable mechanism

This concept has become central to DeFi technology and offers one of the most innovative technologies within this ecosystem. They secure exchanges, loans and borrowings without the need for a trusted third party.

However, it is important to understand the notion of “impermanent loss”. This avoids the bad surprise of getting less money by withdrawing than by depositing.

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