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What Is Liquidity Pool and How Does It Work?


DeFi is a financial ecosystem living digitally on shared infrastructure in cryptocurrency. In DeFi, standard financial services such as lending, borrowing, and trading exist. The only difference is that they operate on a public network. These services use a liquidity pool to help facilitate decentralized trading and reduce the danger of washout. 

By understanding what is liquidity pool, you will be able to earn interest using your crypto effectively. In this article, we are going to discuss the liquidity pool thoroughly. 


What Is Liquidity Pool?

The liquidity pool in cryptocurrency is an essential part of the DeFi ecosystem. It is a collection of tokens or digital assets that are stored in a smart contract. This system creates liquidity that allows faster transactions.

A specific protocol called automated market makers (AMM) uses liquidity pools to allow the automatic trading of digital assets. Therefore, digital assets will not need a traditional market of buyers and sellers to trade. In other words, AMM platform users provide tokens for liquidity pools. Then, the price of the tokens in the pool is determined by the AMM using a mathematical formula.


The Purpose of Liquidity Pool

In every trading situation, both in traditional or crypto markets, traders or investors sometimes face different price expectations and execution. Liquidity pools exist to minimize such issues by incentivizing users and providing liquidity for trading fee shares. 

Trades with liquidity pool programs often don’t need to match the expected and executed price. However, AMM can eliminate the gap between buyers and sellers from their crypto tokens. This will make their transaction on DEX markets more manageable and reliable.

There are various ways how liquidity providers can earn rewards when they provide LP tokens. One is yield farming which allows them to make high returns with a slightly higher risk. Users can do this by distributing their funds to trading pairs, incentivizing pools with the highest trading fee, and LP token payouts. 


How Does Liquidity Pool Work?

As explained before, a liquid pool encourages users to stake their digital assets in a pool to earn rewards in the form of crypto or a part of the trading fees. When a user provides a pool with liquidity, they ofter rewarded with liquidity provider (LP) tokens. These tokens then can be used in the DeFi ecosystem. 

Users who provide the liquidity usually receive LP tokens depending on the amount of liquidity they supply. When the pool performs a trade, the LP token holders will receive a fractional fee that was distributed proportionally. When users who provide liquidity want their liquidity back, their LP tokens will be destroyed beforehand. 

The AMM algorithm, as explained above, maintains the fair market values for the tokens they have. It keeps the tokens’ price within a particular pool. However, other liquidity pools may use different protocols and algorithms. 


Advantages and Disadvantages of Liquidity Pool

Now that we know what is liquidity pools, the next important thing to learn before signing into an exchange platform is the ups and downs of it. Like any investment instrument that relies on technology, Liquidity Pools have pros and cons. 

The advantages of the Liquidity pool include as follows:

1. Exchanging instead of trading

Liquidity pools are different from the usual crypto trading. In crypto trading, you may encounter sellers who offer their crypto at a costly price or want to buy it at an overly cheap price. You will have to be assertive and excellent at negotiating this situation. This may be unfortunate, especially if you don’t have excellent negotiation skills. 

On the other hand, liquidity pools adjust the crypto’s value depending on the platforms’ exchange rate. When exchanging, users borrow from a pre-funded liquidity pool, and they will not receive assets by trading. The exchange rate then generates the assets in the liquidity pool, which creates a fixed cycle.

2. Lower market impact

The transaction in this exchange is a lot smoother compared to crypto trading. That is because you don’t have to face sellers who want a price much higher than the market price. You also will not see buyers that demand a fee too low.

The collection of funds in this system is stored securely in a smart contract, and the values are constantly and automatically updated based on the exchange rates. Therefore, the pricing will be relatively stable.

3. Secure and transparent

The liquidity pool makes everything more secure since it uses publicly viewable smart contracts. This keeps the contract and all information in it transparent and more accessible to audit and secure.

4. A method to earn rewards

This system allows users to provide liquidity and receive rewards, interests, or annual percentage yield on their crypto in return. 

5. Simple transaction 

The transaction performed is at real-time market prices. Therefore, DEX trading becomes more straightforward.


The disadvantages of liquidity pools include as follows:

1. The AMM may reduce the value of your assets

The AMM keeps the liquid in the DeFi ecosystem using the liquidity pools. This way, cryptocurrencies can be traded directly using a straightforward formula. In this formula, when A increases, B will decrease. Then, as the asset’s purchasing power increases beyond the limit, you may experience an impermanent loss when you don’t own the asset.

2. The bug is a huge problem

The non-existence of third parties and the existence of a Smart Contract as the assets’ custodian in the DeFi make transactions using this system a lot easier. However, in case of serious issues or problems, you may also lose your fund. 

Any investment has some risk, which is true in crypto investment. Cryptocurrency possesses excellent opportunities for investment while, at the same time, it also has risks. However, if you want to earn profit from crypto, you will need to learn to take these significant opportunities while at the same time being very careful when investing. 

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