What Is A Liquidity Pool?
A Liquidity pool is an accumulation of funds in a smart contract. Funds in liquidity pools are provided by individuals referred to as liquidity providers. Liquidity pools are essential for the sustenance of blockchains and decentralized exchanges.
A liquidity pool is very much similar to an order book. Trading on decentralized exchanges is usually done in vast numbers. Trading usually requires high liquidity, and traders need to get into trades and exit trades as quickly as possible. However, most cryptocurrency blockchains lack the rate of liquidity needed. Liquidity pools help in solving this problem. It enables traders to get in and out of trade positions quickly even on pairs that would have been very illiquid if conventional order books were used. The funds in a liquidity pool are outsourced.
Liquidity pools are used by decentralized exchanges that also use the Automated Market Maker system. This system differs from order book exchanges because a buyer or seller is not required at the other side of a transaction. Instead, the system executes trades leveraging on crowdfunded, pre-funded liquidity pools. Bancor, an Ethereum-based trading platform, first made use of liquidity pools in trading. However, the system was popularized after Uniswap adopted it. Anyone can be a liquidity provider. Liquidity providers earn by getting a share from transaction fees. This share is calculated based on the ratio of the individual fund to the total funds in the pool.
Liquidity provision is not without its own risk. A liquidity provider can experience impermanent loss if there is a sudden price increase in an asset. This loss can be recovered depending on the fluctuation of prices. The loss only becomes permanent if the liquidity provider withdraws his funds before recuperation of the loss. Another drawback is that many smart contracts have errors in their code, making them susceptible to hacks. Hackers steal thousands of dollars by exploiting these code errors.
Liquidity pools ensure the high liquidity of decentralized exchanges. It also ensures that the power of market makers is reduced since anyone can contribute to the pool – all liquidity providers play a part in decision making. It also provides earning opportunities to liquidity providers.
Liquidity Pool Examples
There are more than 100 of them. Here are a few which are common
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