After School Special: What is a Liquidity Pool?
After School Special is an article series wherein we dive into specific Web 3.0 concepts to provide deeper understanding to our readers. This week, we’re looking into liquidity pools.
Imagine this: You are an apple farmer with enough apples at hand to make apple pies for an entire village, but you can’t even make one strawberry pie because you don’t have a single ounce of strawberries. Because you clearly have more apples than you need, you decide to trade some of them for strawberries. However, after you try reaching out, you realize that the strawberry farmers you’re in contact with either don’t want your apples or are asking for too much of your produce in exchange for theirs, so you don’t proceed with the trade.
Now imagine if in your search for a place to trade your apples, you come across a magical barn where both apples and strawberries are stored by many farmers like you. And its surplus doesn’t end with just apples and strawberries; they have other fruits, too! This magical barn does not refuse your apples, and unlike traders you’ve been to, this barn justly sees the value of your produce and will not take more of it for less than you deserve. And because the magical barn operates under a very specific spell, it doesn’t discriminate. It has no favorite patrons. It is fair and just to everyone. It lets you get the amount of other products proportional to the value of what you leave in it. It also doesn’t let anyone take your apples without exchanging it for another product of the same value.
Now replace those fruits with various cryptocurrencies and tokens. Replace magic with a smart contract and instead of a specific spell, automated market makers (AMMs). That magical barn is called a liquidity pool.
A liquidity pool is a crowdsourced pool of various cryptocurrencies and tokens locked within a smart contract that is used to facilitate trades between users’ assets on a decentralized exchange (DEX). Liquidity pools operate with automated market makers used by decentralized finance (DeFi) platforms to enable an automatic manner of trading crypto assets for a very small transaction cost.
What makes liquidity pools trustworthy?
Smart contracts. As stated above, a liquidity pool is locked within a smart contract, that is a written code on the blockchain that only performs its function once its predetermined conditions are met. And because smart contracts are self-enforcing and permanent, you will always get what you came for once you participate in one.
Automated Market Makers. Liquidity pools also eliminate any possibility of haggling and lowballing the value of your tokens as they operate under automated market makers. AMMs are not reliant on the traditional buyer-to-seller relationship. It is decentralized, which means not one entity is in control of the system and it is accessible for everyone, and it is available any time because AMMs were introduced to eliminate the need for intermediaries in trading crypto.
Basically applying the law of supply and demand, AMMs employ a constant mathematical equation that determines the value of certain cryptocurrencies and tokens depending on the amount of it currently present in a liquidity pool. For example, a pool with 50% Ethereum and 50% Basic Attention Tokens deems both tokens of equal value. However, if more BATs are added into the pool, AMM automatically steps in to increase the value of Ethereum based on the amount of it in the pool compared to BATs. This self-enforcing, automated technology is very important in the very fast-paced DeFi ecosystem. As of late 2021, Ethereum’s design is able process 30 transactions per second. However Vitalik Buterin, one of the founders of Ethereum, suggests a possibility that the coming Ethereum 2.0 may be able to process 100,000 transactions per second. With AMMs technology, users who trade through liquidity pools are certain that they’re getting their token’s worth every time they trade.
Earning crypto by being a liquidity provider
Gemini’s crypto glossary describes liquidity as “the ability to exchange an asset without substantially shifting its price in the process, and the ease with which an asset can be converted to cash.” While liquidity pools are used for trading, it is also a popular place to invest users’ tokens in, and be a liquidity provider.
Each time a trade within a liquidity pool is made, its system automatically charges the trader with a very small amount for that transaction. And as more people do their transactions through that liquidity pool, those transaction fees are collected and then eventually distributed to liquidity providers according to the amount of their investment. Keep in mind though that like any investment, there is a risk of our tokens experiencing a decrease in value. This is called impermanent loss or what happens when price volatility in the open market affects the assets kept in a liquidity pool. Because AMMs determine the values of different cryptocurrencies based on the amount of it currently present within the liquidity pool, your tokens will experience impermanent loss if there are more of the same tokens within the same pool compared to another. However, this loss is only impermanent because liquidity pools are designed to maintain a 50:50 ratio of its tokens and they’ll therefore regain that same value once the liquidity pool is able to restore that balance.
Liquidity pools’ technology is a game-changer in the DeFi ecosystem. It side steps the common problems faced by traders in traditional buyer-seller relationships by eliminating the need for intermediaries. And because they are powered by AMMs and locked within the self-enforcing code of smart contracts, liquidity pools provide everyone in the crypto landscape decentralized exchange platforms that are reliable, readily available, and even allow crypto users to earn passive income by being an investor.