May 31, 2022
Liquidity pools
How do liquidity pools work and why do you need to invest in them?
Let’s imagine that the exchange is a market, with buyers and sellers. Some put up goods for sale, in our case tokens, others buy. It is convenient if you came to the exchange in search of a token and immediately found a seller.
But what if there are no sellers willing to sell tokens at an adequate price or there is no necessary amount of coins.
Imagine that there is a buyer who wants to buy a token for $90 and a seller who gives for $110. Let’s say they agreed, coming to the amount of $100 per token. But this means that either the buyer had to pay $10 extra, or the seller had to concede the cost by $10, which is not beneficial to either side. Also, the exchange may not have the required number of tokens. For example, you need 100 tokens, and only 70 are provided in the pool for purchase.
Here market makers enter the field. They are always ready to buy assets and do not have to wait for other sellers to appear.
However, the presence of market makers slows down the work of the exchange and costs users more. They usually monitor the current value of an asset by constantly changing prices. This leads to a large number of orders and their cancellations. For example, for every interaction with a smart contract on the Ethereum network, a gas fee is charged, so market makers need a large amount of money, constantly updating their orders.
Therefore, it was necessary to come up with and implement a new working mechanism to ensure liquidity on the exchange. This problem was solved through decentralized finance and liquidity pools.
In fact, the liquidity pool is a kind of reservoir of crypto assets that users fill, providing a reserve of liquidity for all pool participants.
A user who invests in a pool receives a higher percentage compared to, for example, a bank deposit. There are also liquidity pools for stablecoins, in which there is practically no risk of volatility.
As a standard, one liquidity pool is represented by a certain pair of tokens, for example, ETH/USDT.
Users, called liquidity providers (LP), add an equal value of two tokens to the pool to create a market. In exchange for providing their funds, they earn trading commissions from transactions that occur in the pool, in proportion to their share in the total amount of liquidity.
Thus, a liquidity pool is a pool of tokens locked on a smart contract that provides liquidity on decentralized exchanges in order to offset the problems caused by illiquidity typical of such systems.
But how do they work exactly?
For example:
There is the first pool provider who buys tokens and is the first to set the asset price. He contributes his liquidity to the pool and receives liquidity tokens for this, further, when the pool trades, the commission from transactions is directly proportional to all holders of liquidity tokens, in the amount of 0.3% relative to the number of liquidity tokens.
Simply put, the holder has 500 tokens that he purchased for $1000, when the platform carries out a transaction, the transaction commission will be sent to the holder of this token in the amount of 0.3% relative to the 500 tokens held, that is, he will receive 1.5 tokens. When the holder of the liquidity token wants to return his pool, he changes his tokens back, receiving his pool + the interest he received for the site’s transactions.
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