Liquidity pools I to facilitate efficient asset trading

Gepubliceerd op 17 oktober 2021 om 11:46

If you have cryptocurrency, you could put your cryptocurrencies to work. One of the options is to stake your crypto. After a certain period, you receive a reward for staking crypto. That reward is the same crypto you staked. That is a great way to earn passive income. But you cannot stake all cryptocurrencies. The reason is that a cryptocurrency has to work on a Proof of Stake protocol. If a cryptocurrency works on a Poof of Work protocol, you cannot stake your crypto. 

Another way to receive passive income is to provide your cryptocurrency in a liquidity pool. What is liquidity and a liquidity pool? What does it mean to provide it? What are the benefits? And what are the risks? How to choose a liquidity pool? What are Automated market makers and trading pairs? In this blog, I will discuss the concept of liquidity pools.

What is a liquidity pool?
Liquidity is something that is very important in the crypto sphere. 

To understand the concept of a liquidity pool, we need to look at an exchange. When a user wants to buy bitcoin (or other crypto currency) through such a platform, this bitcoin has to come from somewhere. This bitcoin comes from a liquidity pool. A liquidity pool can be seen as a pool that is completely filled with cryptocurrency. If you want to buy bitcoin from a certain exchange, you can buy them because there is still bitcoin in the liquidity pool.

What is liquidity providing?

Cryptocurrency operates on blockchain. One of the core elements of blockchain is that it works in a decentralized way (i.e., without a central authority verifying transactions). Decentralized exchanges also exist. UniSwap, SushiSwap and PancakeSwap are examples of decentralized exchanges. These kinds of platforms are also called AMMs; AMM stands for ''automated market maker''. In such exchanges, no one is in charge (unlike centralized exchanges).

In decentralized exchanges, there is no central authority. As a result, this central authority cannot provide liquidity to the decentralized exchange. So someone else have to do this. And this is where the crypto holder comes in. In decentralized exchanges the liquidity is provided by users who offer to provide its cryptocurrency to a liquidity pool (decentralized exchange) themselves. You can then secure your liquidity in a pool of a certain trading pair, so that others can trade in this trading pair via this decentralized exchange.

Simply put, liquidity providing is offering your cryptocurrency in a liquidity pool so that others can trade with them (via trading pairs).

Trading pairs  

The word "pair" or "pairs" stands for pairing, which translates to coupling in English. And that's actually what a trading pair is.

A trading pair is a pairing of two different currencies in order to determine their value in relation to each other.

The point of this is to determine the value of a cryptocurrency. For example, you would not be able to determine the value of one Bitcoin (BTC) without pairing it with another currency.

Once we pair Bitcoin with another currency, for example the Euro, we can determine its value relative to each other.

An example of a trading pair is BTC/USD or BTC/LTC. 

Automated Market Makers

An AMM works similarly to an order book exchange but an AMM functions via trading pairs. However, you do not need to have a counterparty - another trader - to make a trade. Instead, you actually interact with a smart contract that makes the market or trade for you. See the difference here. You do not need another trader to make a trade. The smart contract algorithm does that for you due to the existence of trading pairs. 

Why should you provide liquidity?

In exchange for providing your liquidity (cryptocurrency), you will also receive a reward. This is different from the block reward miners receive. Miners receive a reward for adding a transaction to the blockchain. Providing liquidity is different from verifying a transaction on the blockchain.

  • The liquidity of centralized exchanges is provided by the exchange itself. The fees you pay for trading therefore go to the exchange.
  • At a decentralized exchange the users provide the liquidity. The fees which are paid to trade go to the providers of this liquidity.

There is also another way to earn money from providing liquidity. These rewards are so-called LP tokens.

LP stands for liquidity provider and an LP token is a liquidity provider token. With these tokens you can do various things, for instance, you can swap them to another cryptocurrency, but there are also platforms that offer you the possibility to stake these tokens in order to receive a return (another way to receive passive income).

How do you choose a liquidity pool to provide?

Before you want to use your crypto to provide in a liquidity pool, it is important to choose a pool. Your return (reward) depends on which pool you choose.

What does a pool's return depend on?

First, the return of a pool depends on the volume in a pool. You can imagine that in the pool BTC/USD is a much larger volume than in the pool DAI/HOPR. Since there is a larger volume, there are also more fees that are paid. This means that there is a much larger amount that can be distributed among the liquidity providers.

However, your yield also depends on your pool share. Your pool share is the amount of the pool that is in your possession. Suppose a certain pool has 2 million euros of liquidity. You own 20,000 euros of this pool. You own 1% of the total pool. As noted above, the amount of fees is distributed among the providers of liquidity. The amount of reward (the fees) you receive is the percentage of the pool you own. In this situation 1%. Suppose the amount of fees received is 500,000 euro. This amount is distributed among the liquidity providers. Because you have 1% of the total pool, you will also receive 1% of 500,000 euros, namely 5,000 euros. In this way, your return depends on the pool share you have.

Are there risks in providing liquidity?

There are a few risks to take into account when providing your cryptocurrency in a liquidity pool.

One of the risks involved in providing liquidity is the occurrence of impermanent loss. Very simply, impermanent loss is the loss that you suffer because you have provided liquidity compared to when you would have simply held the currency in a wallet. I will discuss impermanent loss in another article. 

Apart from impairment losses, you cryptocurrency could drop in value (even to zero). This is something you should especially take into account when choosing one of the less established coins. If you are providing liquidity in Bitcoin, the chances of this happening are much lower than if you are providing liquidity in Banana coin (BANANA).

Another risk involved in liquidity providing is the chance that you participate in a scam. New platforms often offer much higher rewards for providing liquidity. Always check carefully which platforms you trust and which you do not. It could happen that you unwittingly participate in a scam and subsequently lose everything.

Tips and factors to take into account

Number one tip is to always do your own research in the liquidity pool you would like to provide. Look at the volume of the liquidity pool, the rewards (is it realistic?), past hacks or issues, reviews (Reddit for example), whitepapers, etc. 

This article was written on August 26, 2021.

BTC address: bc1q3nnm8m2vrsv8med8a38dl37g8l3mm4wa7ph7wj 

ETH address: 0x38b84E2D3B50F83A067A7488C1733180651f418A

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