What is a Liquidity Pool?
Liquidity pools are paired crypto assets that are pooled together to facilitate the trading of particular token or coin sets on decentralized trading exchanges. The funds are provided by the various contributors and they earn a small, passive income based on trading fees between the paired assets they invested in the pool.
As CoinMarketCap puts it, "on such trading platforms, the traditional order book is replaced by pre-funded on-chain pools for assets of the trading pair." They go on to note that utilizing a liquidity pool "does not require a buyer and a seller to decide to exchange two assets for a given price and instead leverages a pre-funded liquidity pool."
How Liquidity Pools Work
As a liquidity lifeguard, I feel it's my duty to explain a bit more about how liquidity pools work before you start engaging in this type of yield farming. After all, jumping into a liquidity pool can be dangerous if you don't know what you're doing. If you're planning on taking a dip in a liquidity pool, it's best you know how to play it safe so you don't get in over your head.
Traditionally in finance, market makers operate using both bid orders and sell orders. In other words, buyers and sellers both place orders for a particular asset, and the median market prices are established based on prices at which those assets are bought and sold for. You'll find these are still standard practices on some of the crypto exchanges like Binance, ProBit, Bittrex, and others.
These types of exchanges have their place in the market, however, they are relatively inefficient when you're looking for instant transactions. Furthermore, due to high gas fees on the Ethereum network, placing buy & sell orders in the traditional way would become infeasibly expensive in the long term. That's where liquidity pools come into play.
Avoiding Slips & Falls
In a liquidity pool, the goal of the protocol is to keep the paired assets' value linked with one another. A protocol like Uniswap tries to ensure that the product of both of the assets provided to the pool remains constant.
Pretend for a moment that you place two assets into a pool, and both of those assets have the exact same value at the time you do so. We'll use apples and bananas for the example. If the price of apples and bananas are both $1 at the time you place the assets in the pool and you choose to put in $100 of each fruit, you'd have $200 in value locked. The exchange rate is essentially 1 banana for 1 apple. However, what would happen if someone from outside the pool came in and decided they wanted to buy a whole bunch of those apples? Suddenly, the price of apples is driven up because there are fewer apples in the pool, and as a result, demand for them will increase.
Remember that the assets being purchased were supplied to the pool by the liquidity providers and that the pooled assets' value must always remain constant. If the value of apples increases and the pooled value must remain the same, it stands to reason that adjustments must be made to the price of bananas. In this example, that would result in a lowering of the value of those bananas, and liquidity providers may end up experiencing impermanent loss on the value of their pooled assets. This is especially true if someone with a lot of buying power spots an arbitrage opportunity between markets. In other words, if a liquidity pool experiences big changes in the pools, you as the liquidity provider will likely lose money.
Liquidity providers will experience impermanent loss at different rates, depending on the pools they choose to invest in. Because some crypto assets are closely tied with one another, while others are not, the risk may increase or decrease. For example, liquidity providers pooling assets like stablecoins have a very low probability of experiencing impermanent loss because stablecoins' sole purpose is to remain at a nearly identical value. They're pegged to fiat currencies, and therefore, it stands to reason their prices should be similar at all times. The same is true for BTC, wBTC, renBTC, etc. These assets should remain closely correlated. However, pairing something like ETH & CRV or YFI & DAI may prove to be riskier as either may fluctuate independently of the other.
Keep in mind that if either of your paired assets increases or decreases significantly, you will lose money. This is another reason why it's sound advice to invest in larger pools. After all, the more assets that are pooled together, the harder it is for price swings to occur. As long as the prices of your assets don't swing too wildly, you can expect to make a good return from swap fees and interest returns.
Additionally, various protocols do what they can to offset the given cost of impermanent loss to liquidity providers by substituting value in the form of extra generated tokens. These will frequently make up for any impermanent loss you suffer, but should you invest in riskier pools, just know the losses can far outweigh the rewards. Finally, should the value of one of your assets drop to $0 in value, you will lose the remaining liquidity in the pool. As a result, you may lose your entire investment.
Make sure to keep this all in mind as you invest and never invest more than you can afford to lose. Like any investment opportunity, investing in crypto and DeFi markets comes with inherent risk. Ultimately, it's always up to the liquidity provider to stay vigilant and make choices that are well-thought-out and well-informed. With that said, stay safe out there and have fun!
Until Next Time
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