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Liquidity Pools Explained

How Do Liquidity Pools Work

Liquidity is a fancy word for money available to be used. Liquidity pools provide the assets needed for automated transactions in DeFi or decentralized finance. In traditional finance, an intermediary, like Fidelity or TD Ameritrade, creates a marketplace for buyers and sellers to trade and receives fees for this service, but in DeFi, users deposit assets into a pool, which is managed by a smart contract. This means users can make trades directly with the pool, no intermediary required.

Each transaction generates a small fee which is distributed as rewards to liquidity providers; the more liquidity provided, the greater the share of rewards they receive. Traders save on exchange fees, and anyone can provide liquidity and earn rewards as passive income.

How Liquidity Pools Work

Typically, two assets are deposited into a pool, at a 50:50 value ratio, and an algorithm controls the price of each asset based on how much of each is in the pool. As users trade with assets in the pool, the algorithm, known as an Automated Market Maker, adjusts the prices of the assets in an effort to maintain the initial value ratio.

For example, if a liquidity pool holds 100 blue tokens at $5 each and 500 white tokens at $1 each, there’s an equal value of each asset in the pool, though the composition of the pool is 1 blue token for every 5 white tokens.

If blue tokens suddenly become really popular, and people start selling their white tokens to buy blue, the price of blue tokens will gradually increase to maintain the value ratio. The price of white tokens might also decrease as more are deposited into the pool in exchange for blue tokens. This is called price impact, the effect of transactions in the pool on the price of the assets in the pool.

What does this mean for liquidity providers?

When liquidity providers deposit assets into a pool, they receive LP tokens to represent their contribution. They are entitled to the percentage of liquidity they have provided to the overall pool. The more liquidity in the pool, the less assets are subject to price impact, but that also means liquidity providers receive a smaller share of rewards.

It’s also important to note how liquidity is used for these trades because this is how rewards are generated. Liquidity is spread out to facilitate trades at any price point, from $0 to $10,000 to infinity and beyond. However, most trades occur within a pretty specific price range, say from $0.99 — $1.01, so liquidity providers only earn on the trades occurring within that price range. This means much of their capital is underutilized, and the rewards are much smaller compared to what’s possible with their full deposit.

Furthermore, if liquidity providers withdraw their deposits after the composition and price of the assets in the pool have changed, they may be left with less value than they started with. This is called impermanent loss. It’s impermanent because users only realize the loss if they withdraw. It’s possible pool conditions will change in their favor, and they can recoup that loss in the future, but of course, there are no guarantees. There are calculators to help you assess any impermanent loss before withdrawing a deposit, but this is one of the biggest hurdles for liquidity providers.

How ICHI Can Help

ICHI offers single asset liquidity provision. Users can deposit just one asset into a vault, and let ICHI’s concentrated liquidity management strategies maximize their capital efficiency. With concentrated liquidity, users can set a specific price range in which to allocate their liquidity. This means higher trading fees, but it also means constant monitoring of trading trends and paying gas fees to adjust the price range for the most efficient use of your liquidity. In other words, if trading starts to occur outside of your designated price range, you earn nothing.

ICHI’s Vaults take the study time, costly fees, and stress out of the equation by actively monitoring those positions, so you don’t have to. You can retain control of your assets, and let ICHI do the rest while you decide which token rewards you’d like to receive. You can learn more about ICHI’s Greedy Liquidity protocol and how it can help mitigate risk and maximize rewards here, and if you have any questions, join us in our Discord!

We made a video to help explain this topic: https://youtu.be/5QrbodqnCb4

Thanks for reading and let us know if you have any questions.



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