Earn fees through locking up your crypto into smart contracts
What are they?
Liquidity pools are pools of tokens that are locked in a smart contract, on a protocol such as Uniswap or Balancer. They are used to facilitate trading by providing liquidity and are extensively used by some decentralised exchanges (DEX’s). Users act as market makers in order to facilitate trading on these exchanges. These protocols allow a user to deposit an equal value of ETH and a token as a pair, which is available for other users in the exchange to trade with.
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. The main reason for this is that the 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 Uniswap, i.e. DAI/ETH, whereas Balancer allows for up to eight assets in a liquidity pool with custom allocations across assets. 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.
When users “tap” into either one of the tokens in your pair, the 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.
Top Liquidity Pool Providers
The best liquidity pool providers all differ in fees, market market algorithms, and token pair distributions:
Uniswap is an ERC-20 token exchange that supports 50% Ethereum contracts, and 50% of other target assets (ERC-20 tokens) contracts. Liquidity providers are rewarded with 0.3% transfer fees.
2. Curve Finance
Curve is a liquidity pool primarily for stablecoin trading. Since the stable coin is not volatile, there is little slippage. The platform doesn’t have a native token but maybe launching a Curve token (CRV token).
Balancer allows anyone to create or add liquidity to customisable pools and earn trading fees, including private, shared, and smart pools. The private pooling allows only the owner to supply liquidity, update parameters, and full permission. Unlike private pools, all parameters like weights, tokens, fees, etc. are permanently set in a shared pool. The smart pool is another variation of private pools where smart contracts control transactions. However, it accepts liquidity anywhere and is tracked with the Balancer Pool Token.
Balancer allows for up to eight assets in a liquidity pool with custom allocations across assets.
As with many DeFi products, users run the risks of smart contract hacks. Also, investors also consider impermanent loss, which is the loss created by providing liquidity for an asset that rapidly appreciates. This is the opportunity cost when providing liquidity for an asset that experiences price appreciation. It is called “impermanent” because if prices revert to previous levels, i.e. $1 per LINK, the capital loss is reversed, and liquidity providers may still profit from the trading fees earned.