Decentralized ecosystems have completely changed our understanding of financial control, challenging traditional beliefs about the overwhelming value of intermediaries in the monetary flows. Safe, efficient, and innovative, this approach has achieved tremendous popularity among cryptocurrency traders within just a few years. There is small doubt that all traders who wish to become successful denizens of the Crypto-Verse should learn how to use it in their interests.
A liquidity pool is one of the crucial concepts of a decentralized exchange, which makes transactions much more convenient and efficient. Hence, what is Liquidity Pool in crypto trading? Let us look into the details of this mechanism and learn more about its features.
What Are Liquidity Pools in Crypto Trading
Well, this is a rare case when the technical term perfectly explains itself. A liquidity pool is exactly that: a pool of liquidity — an assortment of crypto assets, which are locked within a specific smart contract on a decentralized exchange platform. It is a crowd-sourced mechanism. This means that it relies on users who provide liquidity for crypto traders.
Bancor was the first protocol, which incorporated liquidity pools into decentralized schemes, becoming a steppingstone for this innovative approach. However, the concept became truly popular only when Uniswap picked it up. Moreover, liquidity pools played a crucial role in the early stages of the development of the decentralized exchange.
In the early days of decentralized development, exchange platforms were in a vulnerable position, constantly suffering from a lack of liquidity. Liquidity pools provided a strongly sought-for answer to this problem by attracting new users and catalyzing the expansion of the DEX niche.
How Does Liquidity Pool Work in Crypto Trading
How do liquidity pools work in a crypto sphere? While the exact technical details of this mechanism are formidably sophisticated, the underlying principles are quite comprehensible. To understand them better, we need to learn the difference between the two approaches:
· Peer-to-peer trading;
· Peer-to-contract trading.
The first approach utilizes an order book to provide transactions between the clients. However, instead of the classic centralized version, a new scheme relies on automated market makers (AMM). These complicated algorithms make it possible to purchase or sell cryptocurrency assets in an automated manner. By eliminating the need for an obligatory intermediary, they provide on-chain crypto trading — fast, reliable, and without an order book.
Therefore, each time a trader makes a deal, they have no contact with an actual counterparty: a buyer may purchase without a seller, and a seller may sell without an actual buyer. The deal is executed according to the liquidity in the pool. Of course, it does not appear on its own — every user of the decentralized network may become a provider of liquidity. Nonetheless, the AMM algorithm determines the pricing, taking into account all the deals associated with the said pool.
Advantages for Cryptocurrency Traders
The most prominent benefits of liquidity pools for traders include the following:
· Fixed liquidity. This mechanism maintains a constant level of liquidity for each corresponding price level. All participants can make deals even without interacting with their virtual counterparts. Hence, the platform obtains a constant flow of liquidity, whereas its traders get an opportunity to close deals without an order book.
· Guaranteed accessibility. All participants may become providers of liquidity and obtain tokenized rewards for doing so. This is why DeFi platforms are so popular in the first place: unlike rigid centralized structures, they stimulate standard passive earning and yield farming.
· Significantly lower gas fees. Decentralized exchange platforms rely on smart algorithms, which provide the most favorable conditions for cryptocurrency traders, reducing gas costs.
· Optimized pricing. The AMM algorithms always maintain the price of tokens relative to each other within their pool, ensuring that the pool always remains an uninterruptible source of crypto market liquidity.
Passive Income Thanks to Liquidity Pools
With all the benefits of this mechanism in mind, we must approach the essential question: is Liquidity Pool worth it? This mechanism plays a crucial role in maintaining rapid and reliable token transactions. Moreover, traders may also use it for passive mining of tokens. Almost all large exchange platforms reward providers of liquidity with tokenized bonuses for deals upon which they pool crypto assets.
However, it must be noted that this type of investment, while surely beneficial and comparatively comprehensible, still requires at least a superficial understanding of financial trends. Those who are just making their first steps in crypto trading should rely on tutors, including also automated helpers, such as Jet-bot. Such tools allow inexperienced users to engage in automated copy trading by following the lead of the best traders in the market.
This is not the only useful feature of such bots. For instance, investors can take advantage of automated stop-loss and price averaging. However, it is the most beneficial feature for those who lack experience. After following the strategies of professionals, such investors and traders may accumulate enough confidence to determine the perspectives of various liquidity pools on their own.
How to Become a Liquidity Provider
To participate in the decentralized exchange and become a provider of liquidity, you will need to do the following:
· Select an exchange platform. Keep in mind that each platform has certain peculiarities.
· Get in-house tokens for gas to make deals within the system. Each protocol deals in its in-house cryptocurrency.
· Get a wallet for interaction with the blockchain (Metamask or any of the similar ones).
· Hold two assets for providing liquidity.
For instance, you wish to add $3000 to the ETH/USDC pool. In this case, you will need to pay for gas, add $1500 ETH and $1500 USDC. Hence, you will have to cover the gas costs for two separate transactions: the first one is necessary to approve the token, whereas in the second one you need to add liquidity to the chosen pool.
Is Liquidity Pool worth It? Potential Risks
Among all potential risks associated with this type of cryptocurrency trading, the most common are the following:
· Technical flaws;
· Impermanent loss.
The first group of risks is rather simple. Every time an investor initiates interaction with a smart contract, there is a risk of malfunction, which may result in lost data, erroneous program behavior, or even lost assets. In addition to bugs, a trader may become a victim of hackers.
However, the actual danger associated with these risks is rather exaggerated. The largest exchange platforms provide a sufficient level of cyber security, which minimizes the risks of being hacked.
As for the impermanent loss, this risk does not depend on the exact structure of the liquidity pool. On the contrary, this is its inherent feature. It happens when the prices of crypto assets in a pool experience significant swings. The AMM protocols rebalance these prices, which may result in a loss of liquidity.
In other words, the probability of impermanent loss depends on the tokens’ volatility. This is why stablecoins are rare victims of such risks, whereas highly volatile tokens often cause impermanent losses.
Although still in their early stage, liquidity pools offer unique lucrative opportunities for all types of traders. Open to all enthusiasts, innovative, and highly beneficial, liquidity pools represent a cutting-edge approach to crypto trading. Even those traders, who prefer less risky assets than cryptocurrencies, will surely appreciate passive income that comes as a reward for becoming a provider of liquidity.