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What are DeFi Liquidity Pools?

Liquidity Pools (LPs) in DeFi platforms is a collection of cryptocurrency assets provided by investors and locked within a smart contract. These assets may be used for decentralized transactions, such as lending and trading. The higher liquidity provided, the faster and more convenient the transactions.

First, let’s define the commonly used terms to understand this concept better:

  • Liquidity
    In cryptocurrency, liquidity is a coin’s ability to be converted to cash or other coins. Simply, it is the ease of getting your money or completing a transaction whenever you want.
  • Liquidity provider (LP)
    A liquidity provider is an investor who provides the supply of funds for smart contracts because they deposit cryptocurrency into the liquidity pool. Anybody can be an LP and being one can provide a source of passive income.
  • Automated Market Maker (AMM)
    A market maker’s importance in a centralized exchange is its willingness to buy or sell assets at a specific price. It ensures liquidity by providing a meeting point between the selling price and the buying price. In a liquidity pool, that function of a traditional market maker becomes automated and anonymous via the AMM. The AMM is an algorithm that aids asset pricing and is different for every protocol.

How do liquidity pools work?

A liquidity pool is built when an investor pools at least two tokens and locks them in a smart contract. A new market is then created for that set of tokens. As the first liquidity provider, the investor gets the privilege of setting the initial price for that liquidity pool.

The succeeding liquidity providers can add liquidity to the pool as an investment.

How do trades happen in LPs?

For comparison, let’s talk about centralized exchanges (CEx). A CEx uses a traditional order book model, which is a digital list showing the prices and volumes that users are willing to buy or sell. A market maker charges relatively higher fees for facilitating a transaction.

Decentralized exchanges get rid of this intermediary process by using AMMs, the algorithm that sets the price of assets in the pool. The ratio of the tokens in the pool automatically dictates the price of the tokens.

The presence of AMMs allows users to directly trade with each other, more commonly referred to as “Peer-to-peer (P2P) Trading”.

What do liquidity providers get?

Liquidity providers receive Liquidity Provider Tokens (LPTs), which are representative of receipts or proof of ownership of their share in the pool. The amount of LPTs received is proportional to the liquidity that each provider supplied to the liquidity pool. LPs can earn more by using the LPTs to stake or trade-in other protocols of the same blockchain.

When a trade takes place in the liquidity pool, a fee is charged on the transaction. The collected fee is distributed proportionally among the LPs, based on the amount of liquidity they supplied to the pool.

Risks in liquidity pools

There are risks inherent in liquidity pools such as impermanent loss and smart contract bugs. Impermanent loss is when the value of the asset you deposited decreases over time. Be wary of impermanent loss during extreme volatility or price fluctuations. While that concept makes this passive income a risky model, take note that it is still a very profitable activity.

Another risk worth noting are smart contract bugs that may subject your funds to risks. Your funds in a liquidity pool are controlled by a smart contract with no custodian. Should that contract be exposed to vulnerabilities, there is the possibility of loss.

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