Understanding liquidity pools

Understanding liquidity pools

By yanis | little crypto guides | 5 Aug 2020


What's the common thing between dapps on the thumbnail ? liquidity pools

But... what's a liquidity pool ? Another unused technical word ? A revolutionnary (and a bit FOMOist) thing ? We will see that in this article.

 

Used instead of order book

On classic exchanges, when you buy something, you make/fill an order, and choose order price. It's good in most cases, but if volume is low, it becomes... very hard :

low-volume

Just see. If someone sells, he will have to sell at 1 sat, but if he buys, he will buy at 3 sats and lose many money. 

On a liquidity pool, you doesn't post an order (and u doesn't choose price, but I will talk about later), but you put/take into a pool. For example, if you want to buy 1 eth for usdt, you will but the required amount of usdt to the pool, and receive your usdt from the pool.

 

Impact on price

A big difference between pools and order books is price calculation. If on standard exchanges, price is price of last trade, exchanges like uniswap calculate it from ratio of coins in pool.

For example, if eth-usdt pool contains 1M eth and 400M usdt (an 1:400 ratio), one ether will be 400 usdt.

If you make a trade, you also can see a "price impact" info. It's only the after-trade ratio of coins in the pool.

 

Who funds the pool ?

I wrote that we took coins from the pool and put other, but, where do these coins come from ?

It come from users, who can deposit to (pool tab on uniswap). You will have to provide coins following actual pool ratio (for the last example, providing 1 eth for 400 usdt), for keeping it good.

Another good thing is that you will earn on fees paid for trades, that're given to liquidity providers, and that pools are stable (you doesn't have 1 eth and 400 tether, but x% of the pool, following the current ratio)

 

Is it really better ?

I can't say if one or another technology is better or not. It's depending on purpose, but I can give pros and cons.

 

Pros

  • Good for low-volumes
  • Fees are given to liquidity providers
  • Instant (not to wait for getting ur order filled)

Cons

  • Not good for traders (where are stop-limit orders when there isn't any order ???)
  • You cannot set the price

 

It's the end of this explanation, I hope that you liked (and understood) it

If you did, please give a tip and a like (thanks)

If you didn't understand something, feel free of saying it in the comments



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