CryptopediaWhat is a liquidity pool and how does it work?

What is a liquidity pool and how does it work?

In this article, I will explain exactly what a liquidity pool is? How does liquidity pools work and then how to actually go ahead and use them to earn extra income from traders on your own coins. You don’t have to give up ownership of your coins but you can earn fees for providing a service for other traders who want to swap and trade those coins and we can earn passive income directly from doing that.

What is a liquidity pool in crypto?

Liquidity pools are smart contracts that allow investors to trade coins and tokens regardless of if there are any buyers or sellers. In the liquidity pool, there is no order book.  In an order book, it requires a buyer and a seller to meet at a certain price for the transaction to happen. This is where a liquidity pool which is a pool of money comes to the rescue. It will let you trade an asset regardless of if there is a buyer or a seller. 

In simple words, a crypto liquidity pool is just simply a very big collection of a huge bucket full of coins that enables a trader to swap one coin in. and therefore take another coin out. Obviously, it provides liquidity for the market and traders pay fees for that liquidity when they trade and swap coins. The key difference in crypto though versus the traditional markets is that with crypto liquidity pools we can actually add our own coins into the pool and earn trading fees from people that use our liquidity to swap those coins. 

Orderbook vs AMM

How does liquidity pools work: There are two main types of liquidity pools one is an order book suppose Binance and another one is called a market maker or in crypto, it’s an automated market maker. There are many know a days like Uniswap and pancake swap which we’ll discuss in this article.

with an order book style, you have a buyer and you have a seller and they come to the market and show their orders on the order book. This happens in Binance or any other centralized exchange for selling some crypto you need a buyer for it. In the order book, you can see anyone’s order or anyone showing order to you. There is a buyer and seller order in the order book if someone is willing to buy 2 Ethereum he will put an order and if someone is ready to sell at your desired price your order will automatically fill. So same happens when you want to sell your 2 Ethereum you put an order that I want to sell 2 Ethereum for supposing $100$ and when a buyer comes and is ready to buy at $100 he will buy it from you.

This type of order book works extremely well for very liquid markets that have a ton of trade and very large volumes in terms of the way that they trade so you have a buyer and a seller. The downside of this is who’s making money here from all of this trading and the trading fees that you pay. Well, its centralized companies take all of our trading fees. I pay trading fees when I buy and the seller is also paying trading fees to centralized exchanges like Binance. So Binance charges fees from both of us simply for providing a venue a liquidity venue so we’re paying finance for running this business.

What a market maker is or in crypto?

How does liquidity pools work: An automated market maker is a different way of trading and a different way of getting price discovery. When you want to trade you need to know what price you’re actually going to trade at. So when I was trading stocks I deal with market makers all the time. I actually deal with actual people who made markets. But they had a book and they were a market maker who made prices both buy and sell. With the crypto obviously, it is all automated therefore an automated market maker but you can have a system like a Uniswap that makes prices and so if we want to sell Ethereum we can actually get a price for that. So in Uniswap, there are no orders you can’t see liquidity. It just gives you a price for your desired asset.

So how does it get this price? Well, what actually happens is there is a giant bucket or a liquidity pool of assets. From the pool, two tokens have a ratio. The ratio is the price so instead of having a buying instead of having a buyer and a seller meet up and show all of their orders. What you have is a buyer right gets given a price because the pool is telling him exactly what that is. The pool works this out via some supply and demand characteristics.

Suppose there are 2,940 dollars per one Ethereum in the liquidity pool and so that is the price that I swap at. So I go to the pool as a buyer and it tells me that if I want to buy one eath I have to put into the pool to 940 and then out I get my Ethereum. Now the key difference here is that I have not matched up with a seller of Ethereum instantly. On an order book, these coins are just sitting there 24/7 in that ratio giving me that price that enables me to trade any time of day. 

Also, get a price for cryptos that potentially don’t have as much volume. Order books are great for high volume high turnover markets. Market makers are great for lower turnover you know smaller volume and cryptos that don’t trade as often you can’t show orders on an order book for very illiquid crypto. Because you can really crazily change the market. So for a very basic level, there’s a ratio of coins and you just swap them in and out and you don’t need to match with a seller instantly. The coins are just waiting there for you to do that.

How does liquidity pools work: There are many pros and cons of each type of liquidity pool but specifically with Uniswap or other AMMs. The key benefit is that we can provide our coins to those pools and then earn trading fees from traders.

How an AMM works?

This is how it works you have a liquidity provider that could be me myself. What I do is I deposit my tokens into the pool in a specific ratio because they have to have a ratio that therefore has a price one versus the other. Suppose you have two tokens, token A and token B in that ratio you then get something called an LP token which gives it’s essentially a receipt to tell you how much of the pool you actually own. It is obviously important if you want to take your assets back out again or if your receipt tells you how much of the fees paid that you actually are entitled to. You will get those LP tokens directly into your wallet. Now from a trader’s point of view when they come on what they do is they see the ratio of the coins they get a price and then they swap one for the other and they get that in a ratio and of course they pay this fee suppose $0.03 that fee obviously goes to us because we are providing liquidity.

Related: What is arbitram? Its impact on chain-link and Uni swap.

Price changes

How does liquidity pools work: The way that an automated market maker has price discovery unlike on an order book is to change the price based on each trade. So the price will obviously change depending on the supply and demand of the coins in the liquidity pool. When a trader trades they put two tokens in a ratio and pay their fee.  What happens is the ratio of both coins is going to change because there’s a supply and demand difference. 

Actually, a protocol that takes place that tries to change the price a little bit depending on the supply and demand of the tokens in that pool. So obviously if one of the tokens is getting bought and becomes scarcer within the pool that means that that asset becomes more expensive compared to the other coins. There are more of the other coin in the pool and less of this coin and so the price goes up little by little. There’s a protocol that dictates this so each trade in the AMM pool changes the price slightly which is obviously needed. Because of the supply and demand, traders pay 0.3 percent when they swap but the trading fees go to the people that provide their assets in the pool and not the venue itself. In fact, the venue may take around 10% of the actual trading fee in reality but most of it actually goes to the people providing their tokens as liquidity.

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