Liquidity Pools

Provides liquidity for traders on DEXs

Relevant terms to know:

Relevant risk:

What it is:

Liquidity pools are pools of tokens that provides liquidity to DEXs. Investors (AKA LP's) act as market makers, using AMM (automated market making) mechanisms on these exchanges. In its most basic form, liquidity pools keeps a 50:50 value ratio between ETH and a second token. 

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.

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