The cryptocurrency market is a very active community that initiates thousands of transactions to be verified daily, but verifying transactions can be pretty slow.
Crypto liquidity pools provide a faster means of turning digital assets into cash, and this option can be helpful for people who make frequent transactions.
This article will inform you about liquidity pools, how they work, and several other things you should know about them.
What is a liquidity pool?
A liquidity pool is a smart contract containing large portions of cryptocurrency, digital assets, tokens, or virtual coins locked up and ready to provide essential liquidity for networks that facilitate decentralized trading.
A decentralized exchange relies greatly on liquidity because of the regular rate at which transactions are made on their network; for this reason, decentralized exchanges need to be connected to liquidity pools that can help maintain a steady functional network that doesn’t delay transactions made by traders.
In crypto liquidity pools, digital assets are locked and ready for exchange. Liquidity pools serve as a digital asset reserve that can provide liquidity to help speed up transactions for decentralized finance (also known as DeFi) markets such as decentralized exchanges (also known as DEX).
Unlike traditional finance, which pairs buyers and sellers to complete a transaction, liquidity pools do not need to connect users to complete a trade. Instead, they function automatically through automated market makers (amms) that connect you to the smart contract with your requested digital assets locked up in them.
Automated market makers are algorithmic protocols that determine digital asset prices and automate asset trades on liquidity pools.
A liquidity pool gathers its assets through users called liquidity providers (also known as LPs), who contribute to a percentage of the crypto asset in a typical liquidity pool smart contract.
How do liquidity pools work?
Liquidity pools use automated market makers (AMMs) that connect users aiming to trade pairs with the appropriate smart contracts for them. AMMs are the protocols used to determine the price of digital assets, and it does a great job of providing the most reasonably accurate market price on liquidity pools.
Before liquidity pools can achieve their principal function of providing enough liquidity for crypto markets worldwide, they will require the tokens of liquidity providers.
To become a liquidity provider, you can adapt the steps below to any liquidity pool platform of your choosing:
- Credit your crypto wallet with the crypto tokens you aim to lock up in a liquidity pool and connect it to the liquidity pool platform of your choosing or sign up on a liquidity pool platform and credit the liquidity pool wallet of your account on that platform’s wallet.
- Find the trading pairs you’d like to invest in and deposit an equally divided portion of your crypto investment into that trading pair; for example, to invest $1000 into an ETH and USDT trading pair, you would need to deposit $500 each in both ETH and USDT on that liquidity pool.
Once you’ve made your deposit, select the period you want to have it locked up in the pool.
After the period of lockup has elapsed, you, as a liquidity provider, will be rewarded with liquidity pool tokens according to your selected trading pair and liquidity pool platform.
However, during the lockup period, you will also acquire an earning portion of the transaction fees paid to make exchanges with the pool you committed your crypto.
Some crypto liquidity pools also provide the option of staking liquidity pool tokens in exchange for earning the platform's native token.
Why are liquidity pools important?
Liquidity pools play a significant role in providing liquidity in illiquid markets and boosting the DeFi ecosystem. The low liquidity that peer-to-peer exchanges offer can slow down the speed of transactions in financial markets. Still, with the help of liquidity pools where tokens are locked up in smart contracts, people can make transactions quickly.
The price of assets on crypto liquidity pools is also very fair. They can only be influenced by the current market exchange rate, which offers relatively accurate prices for the assets they supply to liquidity pool intelligent contracts. Unlike traditional exchanges, where buyers and sellers can influence the bidding price of their transactions with other traders, liquidity pools provide a more consistent environment where prices can be more accurate.
Pros of liquidity pools
With sufficient liquidity being provided through liquidity pools, you can make faster transactions and turn your tokens into cash within a shorter period.
Liquidity pools provide a faster means of making transactions than P2P exchanges, which require traders to release assets, verify trades and spend some time making transfers needed to complete the exchanges.
Liquidity pools already have reserves of the crypto pair you wish to exchange, allowing for faster, trustworthy exchange.
Secured exchange with reduced possibility of scam
The process through which users of liquidity pools acquire their crypto pairs is secure compared to that of a P2P transaction.
P2P transactions require two users to trust each other to complete their end of the contract. Still, with liquidity pools, automated market makers (amms) automatically connect users with contracts containing their trading pairs.
Amms also releases the crypto already locked up in smart contracts. With such a system, people making transactions on a crypto network can quickly receive their assets without the possibility of the other trader refusing to release them.
Fair price on exchanges
Prices offered for exchanges on liquidity pools are not influenced by bias or greed, which P2P exchanges can be affected by because traders determine the trading price of their exchanges.
Amms provides the market price for making exchanges on liquidity pools, and the prices amms provide are based on authentic information that users can trust.
Cons of liquidity pools
Scam Liquidity Pools
The smart contract code of a liquidity pool may be accessible to developers. Developers with such access can breach the smart contract by obtaining all your assets locked in the liquidity pool without your permission.
For this reason, users of liquidity pools are advised to do extensive research on the integrity of the liquidity pools they connect to their wallets and read the terms and conditions of the smart contract they join.
Risky price change
Since Automated Market Makers (AMMs) determine prices on liquidity pools, assets locked up in their smart contracts are subject to constant change.
Amms constantly update the prices of trading pairs on the list of trading assets they offer on pools.
The change in prices offered by liquidity pools can lead to a significant loss or gain of assets stored in the pool.
The crypto market is volatile, and a tremendous price change can lead to losing assets locked up in a pool.
Volatile changes can easily affect small asset portions, and lost assets may be unrecoverable for investors who only lock up a small asset portion to a liquidity pool.
Trending liquidity providers
Balancer is a platform used to generate DeFi liquidity in a private or public way. It also provides incentives for liquidity providers who participate in their liquidity pools.
Uniswap is one of the most popular liquidity pools in the crypto market. It allows users to exchange trading pairs on its network for free and keep providing liquidity by doing so.
It functions on an Ethereum network and allows the trading of ERC-20 tokens in a decentralized manner.
Providing liquidity is the protocol for every day at curve finance. They provide significant liquidity for traders looking to trade stablecoins on an Ethereum network.
Liquidity pools vs. order books
Liquidity pools complete trades through a process different from order books.
On liquidity pools, traders receive their assets directly from a smart contract with trading pairs ready for exchange.
Order books, however, require the intervention of the platform and traders involved in the exchange before traders can release assets to the appropriate people.
Liquidity pools use Automated Market Makers (AMMs) to price the assets locked up for an exchange, but unlike liquidity pools, order books are used by centralized exchanges to price the crypto assets traded on their platforms.
How much do liquidity providers earn?
Liquidity pools may operate differently depending on the platform, which accommodates the process, but one way those who provide liquidity on crypto liquidity pools can earn some return on their contribution is through yield farming.
Yield farming (also known as liquidity mining) is the protocol that allows a liquidity provider to lock their crypto assets in a protocol to generate rewards in the form of tokens.
The rewarding earnings gathered from liquidity mining can either be high or low depending on the amount of risk involved in the protocol.
A liquidity provider gets rewarded with a profit percentage in exchange for supplying digital assets to any liquidity pools connected to their wallet.
The amount of profit a liquidity provider makes from a yield farm depends on how long they retain their crypto assets within the crypto liquidity pool of that yield farm.
Profits made by a liquidity provider may also be in the form of liquidity pool tokens (or LP tokens) equivalent to the number of crypto tokens they contribute to the decentralized pool or fractional trading fees divided amongst the liquidity providers whenever a trade is facilitated on the liquidity pool.
Are liquidity pools safe?
Liquidity pools provide a lot more safety than order books. Order books are safe for traders who don’t release their assets until they verify the other trader's commitment. Still, liquidity pools cut through the waiting time and release users' assets faster since the assets are already locked in smart contracts.
Although a liquidity pool ensures the safety of your transactions, the safety of your tokens within the liquidity pool depends on the amount of research you do before participating in them.
The crypto market is very active and requires a lot of cryptos to function. Locking up some crypto away to conveniently provide investors with the necessary assets is an innovation that strengthens networks.
With the regular rate at which crypto networks are being used, liquidity pools are one of the most remarkable ways decentralized exchanges can maintain fast transactions on such volatile networks. Liquidity pools will continue to provide a sustainable network for investors looking to make passive income.