Liquidity Pools

Provide Liquidity for DEXs

Relevant Terms

Market Making
AMM
Impermanent Loss
Order Books

Leading Products

Bancor
Curve
Uniswap
Balancer
SushiSwap

Liquidity Pools are pools of tokens that provide liquidity to DEXs. Investors (AKA Liquidity Providers) pledge coins or tokens to a pool that can then be used by traders to buy and sell. DEX’s like Uniswap employ AMM (automated market making) mechanisms to price tokens in response to demand. 

The market making algorithm asymptotically increases the price of the token as the desired quantity increases. Liquidity pools are configured between two assets in a 50:50 ratio on on DEX’s like Uniswap, i.e. DAI/ETH. It is this ratio of tokens that determines their relative price. For example, if someone buys ETH from a DAI/ETH pool, the relative quantity of ETH falls, so its price rises, with the opposite effect on the quantity and price of DAI. The bigger the trade, the greater the effect on the relative prices.

As incentive to provide liquidity, LP’s (liquidity providers) are paid a percentage of transaction fees from trades that occur in the pool. Liquidity pools typically issue governance tokens that enshrine the rights and rules of liquidity providers. They also allow that LP’s can vote on the rules of the pool. These tokens themselves often carry an exchange value and are part of the overall profitability calculation when deciding to provide liquidity to a pool.

When traders “tap” into either one of the tokens in the pair, they must match it with an equal amount of the other token. Liquidity providers on Uniswap are rewarded for providing liquidity with a 0.3% transfer fee whenever that pool facilitates a trade. This is then split among all the liquidity providers in that specific pool based on how much of the pool they’re offering.

​Don’t forget about gas fees that have to be paid when depositing and withdrawing, as that will factor into the overall profitability of providing liquidity.

Liquidity pools such as those on Uniswap use a constant product market maker algorithm that makes sure that the product of the quantities of the two supplied tokens always remains the same. Because of this algorithm, a pool can always provide liquidity, no matter how large a trade is. In periods of lop-sided price movement, prices will adjust enough to attract demand and keep the pool ratio at parity.

This is essential to preventing slippage and keeping traders happy. Given the myriad trading venues, traders can exploit arbitrage opportunities when the price of a coin in a liquidity pool becomes untethered from the price of the same coin at another DEX or CEX. As more liquidity comes online, these arbitrage opportunities will diminish. 

Video by: Finematics

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Uniswap

Uniswap is a trading platform with the largest trading volumes of any DEX. Traders can provide liquidity to pools and earn interest and governance tokens, or they can trade  and take long/short token positions.

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