HomeCrypto blogWhat is a Liquidity pool in Crypto & How does it Work?

What is a Liquidity pool in Crypto & How does it Work?

A liquidity pool is a contract that allows its users to trade coins and tokens regardless of any buyer or seller. How does liquidity pools work? It does not work like a stock market where buyer and seller both submit their order of how much and at what price they will buy or sell their assets. 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 regardless of what time of the day it is and regardless of the price.

How does liquidity pools work explained

How does liquidity pools work or a dex run and attract liquidity this is where something called a liquidity pool was created. A liquidity pool is a contract that holds two separate assets that equate to a pair and each trading pair has its own liquidity pool containing both assets. 

Example loop ust the pair is if you want to trade from you’ve got some USD you want to trade it for loop that becomes a pair. If you want to trade USD for luna that becomes a pair as well. So to have a liquidity pool there’s a liquidity pool for each individual pair so if it’s ust and loop there will be a liquidity pool holding both of those assets. These two assets are placed into the pool at a 50-50 ratio in value and it enables there to always be enough assets to execute the swap smoothly. If you want to sell loop for ust there needs to be ust to be received on the other end. Same on the other side of vice versa. If you want to buy a loop there needs to be some loop available already in the pool for you to be able to buy it from. Because if there’s no loop on the other side you can’t buy it. 

The liquidity pool makes sure that there’s always an equal value of both assets in the pool so you can buy and sell very easily. There’s always something there to buy. If there’s not enough then obviously the price is then going to move and that you know obviously causes price movement so you’re trying to reduce that as much as possible.

How much can we earn in crypto liquidity pools?

In a liquidity pool, if you want to provide liquidity to a pool you have to add each asset into that pool in a 50-50 ratio. In return, you will receive what’s called an LP token or liquidity provider token. An LP token is the representation of your ownership in that particular pool. It now enables you to receive yields from that pool to receive money from that pool. 

Let’s just say you own 10% of a particular pool in terms of value and liquidity then you put in that amount and you get an LP token that represents a 10% of that pool. On loop as a liquidity provider, you receive 75% of the trading fees accrued on that pair proportional to your share in the pool.

These rewards are claimed when the liquidity is removed from the pool. Imagine you own that liquidity-provided token that those liquidy provider tokens that are you know the representation of ten percent of the pool. You receive then you’re going to receive 7.5% of all the trading fees of people swapping that pair because you own 10% of the pool because 75% goes to that pool. The more that you own so if you own 20% then you’re gonna receive 15% of trading fees in that particular foot pool.

So the more people trading back and forth they’re paying trading fees every single time and that’s accruing and you’re earning interest. These aren’t just created to reward LP providers and liquidity providers and make the pools more attractive. But what it does is it also keeps these yields more consistent during times when there’s you know fewer people trading and so the trading volume. There are fewer fees so it keeps it more stable and more attractive when there isn’t as much trading.

This is done by uh lending your liquidity provider tokens to the protocol in return for you know tokens and incentive yields. The LP providers get additional bonuses and yields in loop tokens and in the future other tokens for providing liquidity to the pools. What they do is they lend out these LP tokens to the protocol through something we call farming liquidity farming. we’ll explain that in the next article. 

How does liquidity pools work: What’s really powerful about the loop, especially around the trading side and the dex side. Is that loop helping bridge assets like Ethereum, Solana and bitcoin to be traded on the terra network and on loop? It’s huge at the moment because right. Now what’s happening and the big roadblocks in d5 and crypto is that we’ve got all these different networks and these different chains like Ethereum and Solana. 

They don’t communicate with each other and a large portion of them can’t trade pairs with one another. It’s becoming bigger but for the most part, you might have a decentralized exchange built on Ethereum and you can’t trade terror assets on top of that exchange. Because they don’t communicate with each other. It’s a huge opportunity you know loop being built on top of tera. Tera has built the capabilities to bring coins from others and tokens and pairs from others you know chains to onto the terra network and on to loop. 

It’s a huge opportunity to have assets like Ethereum, salon, and bitcoin tradable on the loop decks with tera pairs amongst other things. This will attract a large influx of users. It will track a lot of trading volume and that means more trading fees to the platform which then benefits liquidity providers. So it’s a huge loop having that because it means attracting more traders more people more pools more people wanting to trade pairs on the pool, So the liquidity providers make more money and more yields.

Price Impact

How does liquidity pools work: For now, you will need to know the term price impact. This means by how much can the price be affected.

If the pool only has a thousand dollars worth of Ethereum and one thousand dollars worth of bat tokens. By dropping eight hundred dollars into the poll you can affect the price of either asset by a lot. But if the pool was as large as a few million dollars eight hundred dollars would have almost no effect on the price. This means that the smaller the pool the larger the price impact. 

Arbitrage Trading and Flash Loans

Another way you can make money with liquidity pools is by arbitrage trading. If the price of Ethereum in our pool fails to a very low number because someone was depositing a lot of Ethereum to buy bat tokens. 

An arbitrage trader can come along buy Ethereum from our pool for very cheap and sell it to let’s say Coinbase for more. It might seem like they are earning their money by just buying in one place and selling in another. They are actually delivering a very important service of balancing out the prices in the pools and other exchanges. Many of them use flash loans which allow you to borrow millions of dollars for a very short period of time. You the viewer can also use flash loans and actually hold in your custody of millions of dollars but only for 13 seconds or so since that’s the average Ethereum block time.

Examples of Liquidity Pools

There are many Liquidity pools in the market like pancakes & Uniswap. Uniswap allows you to trade almost any Ethereum token with another Ethereum token for a very low fee. They are able to provide such variety by something called routing. Which is connecting two liquidity pools together and that is what most decentralized exchanges do. Some polls can also become very complicated by allowing many assets to be traded in one liquidity pool like balancer which allows eight assets.

Read: What is the metaverse, and metaverse use cases?


How does liquidity pools work: The pool starts off with an exact 50-50 ratio of two coins or tokens let’s say Ethereum and basic attention token bat. If you decide to buy some bats you will need to give the pool some Ethereum. The more Ethereum you deposit into the liquidity pool the less an Ethereum will cost and the more expensive bat will become.

This is because the automated market maker is an algorithm that will try to keep the 50-50 ratio constant. So it will make each next bat token you are trying to buy more expensive. Remember that each trade also has a very small fee which goes to liquidity providers people that invest in the liquidity pools to make trades available. You can easily earn money out of it by providing liquidity to any liquidity pool. You must remember about impermanent loss and rug pull which are two major risks involved when investing.



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