What is a Liquidity Pool in Crypto? (How to PROFIT from Crypto LPs)

What is a liquidity pool in crypto?

A crypto liquidity pool is just simply a very big collection or huge bucket full of coins that enables a trader to swap one coin in and therefore take another coin out. Obviously, it provides liquidity for the market and traders pay fees for that liquidity when they trade and swap coins. The key difference in crypto, though, versus the traditional markets, is that with crypto liquidity pools. We can actually add our own coins into the pool and earn trading fees from people that use our liquidity to swap those coins. I’m going to explain exactly what a liquidity pool is.

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I am going to tell you how they work and then how to actually go ahead and use them to earn extra income from traders on your own coins. You don’t have to give up ownership of your coins, but you can earn fees for providing a service for other traders who want to swap and trade those coins.

Orderbook vs AMM

Firstly, we have to understand what a liquidity pool is and I’m going to show you that by showing you the difference between the two main types of liquidity pools. One is an order book, which I’m going to illustrate with Binance, and the other is called a market maker or in crypto it’s an automated market maker. I’m going to show you UniSwap, but there are others as well, for example, Pancake Swap. So what I want to go through first is exactly what an order book style market is and you can see that right here.

 So with an order book style, you have a buyer and you have a seller and they come to the market and show their orders on the order book (See Picture below). You can see it right now live. This is the ethereum market. On the left hand side, you can see the order book right here. It changes tick by tick. You can see everyone’s orders. Everyone is showing their orders to you. So what I can see here is that this price, obviously, the highest price right here is 2940.32 and on the right hand side you have a size. This is the amount of Ethereum that people are wanting to buy. As you can see here, everyone is showing their order. They’re showing you the exact price they want to pay. They are showing you how much they want to buy. This can be a collection of orders, not just one person, and then the system works out what the actual value of that is.

Above this, you can see the sellers right here. The people that want to sell their Ethereum. Obviously, this is trading in US dollars. They are showing you the price that they’re willing to sell at and the amount at that price that is available to sell.

This type of order book works extremely well for very liquid markets that have a ton of trade and very large volumes in terms of the way that they trade, you have a buyer and a seller. As you can see down here, they show themselves and then match up at a certain point. The point that they match up at is right here in the middle. You have all these buyers right here. As you can see, 2861 is the best bid and 2861.01. is the best offer.

So you have sellers on top and buyers on the bottom. When that price actually meets, that’s when a trade goes through and that is when you trade. The downside of this is that someone’s making money here from all of this trading and the trading fees that you pay. Well, it’s Binance. This centralized company takes all of our trading fees. I pay trading fees when I buy. The seller is also paying trading fees. So Binance is taking fees from both of us simply for providing a liquidity venue. That’s where the liquidity is. This is where all of the traders are, and so we’re paying finance for running this business.

In this article we have to get into what a market maker is, or in crypto, an automated market maker. This is a different way of trading and a different way of getting price discovery. When you want to trade, you need to know what the price that you’re actually going to trade at is. So when I was trading stocks, I dealt with market makers all the time. I actually dealt with actual people who made markets. They had a book and they were a market maker who made prices both buy and sell. With crypto, obviously, it is all automated, therefore an automated market maker, but you can have a system like UniSwap, that makes prices and so if we want to sell Ethereum, we can actually get a price for that U.S dollars 2940.2.

As you can see, there are no orders. I can’t see the liquidity. It’s just um giving me a price. So how does it kind of get this price? Well, what actually happens is there is a huge bucket or a liquidity pool of assets and in the pool these two tokens have a ratio. So instead of having a buyer, instead of having a buyer and a seller meet up and show all of their orders, what you have is a buyer who gets given a price because the pool is telling him exactly what that is. The pool works this out via, you know, some supply and demand characteristics, so when the pool sees that there are around $2,940 per one ETH. Obviously that’s a ratio, so there could be millions of dollars in here and a ratio of Ethereum, but that is the ratio. There are $2,940 dollars per ETH in the liquidity pool. That is the price that I swap at.

I go to the pool as a buyer, and it tells me that if I want to buy 1 ETH, I have to put in $2,940 and then I get my Ethereum. The key difference here is that I have not matched up with a seller of ETH instantly, like on an order book. These coins are just sitting there 24 hours a day at a price that enables me to trade any time of day and get a price for cryptos that potentially don’t have as much volume. Order books are great for high volume, high turnover. Market makers are great for lower turnover, you know, smaller volume and cryptos that don’t trade as often. You can’t show orders on an order book for a very illiquid crypto because you can really crazily change the market. So for a very basic level, there’s a ratio of coins and you just swap them in and out and you don’t need to match with a seller instantly. The coins are just waiting there for you to do that.

Crypto passive income with liquidity pools

There are pros and cons of each type of liquidity pool, but specifically with UniSwap or other AMMs, the key benefit is that we can provide our coins to those pools and then earn trading fees from traders. So this is how it works:

You have a liquidity provider, which could be me, and what I do is deposit my tokens into the pool in a specific ratio because they must have a ratio and thus a price one versus the other.

You can see what happens here is that you have two tokens, so token a and token b in that ratio. You then get something called an LP token, which is essentially a receipt to tell you how much of the pool that you actually own, which is obviously important if you want to take your assets back out again. Or your receipt tells you how much of the fees paid that you actually are entitled to. You get those LP tokens into your wallet. From a trader’s point of view, when they come on, what they do is they see the ratio of the coins, they get a price and then they swap one for the other, and they get that in a ratio. Of course, they pay this fee of 0.03. That fee obviously goes to us because we are providing liquidity. 

Price changes

The way that an automated market maker has price discovery, unlike on an order book, is to change the price based on each trade. So the price obviously has to change depending on the supply and demand of the coins in the pool.

So what you can see here is that when a trader trades, they put two tokens in in a ratio and pay their fee, but what happens is that the ratio of one of the coins is going to change, well both of the coins are going to change because there’s a supply and demand difference.

What you can see here is that there’s actually a protocol that takes place that tries to change the price a little bit depending on the supply and demand of the tokens in that pool. So, obviously, if one of the tokens is getting bought and becoming scarcer within the pool, that means that that asset becomes more expensive compared to the other coins. There are more of the other coin in the pool than of this coin, and so the price goes up little by little. There’s a protocol that dictates this, so each trade in the AMM pool changes the price slightly, which is obviously needed because of the supply and demand. Traders pay 0.3% when they swap, but the trading fees go to the people that provide their assets in the pool and not the venue itself. In fact, the venue may take around 10% of the actual trading fee in reality, but most of it actually goes to the people providing their tokens as liquidity.

Crypto liquidity pools on Uniswap

To show you how a liquidity pool works in practice, we can go over to UniSwap and see all of the most active pools, so you can see the amount of volume or value that’s locked in all of the pools:

It’s obviously going up quite significantly. If we come down here, what you can see is the most active pools, so the number one on UniSwap is USDC versus ETH:

You can see that traders pay 0.3% fees to the people adding their coins to the pool, so if you want to do that, you can earn those trading fees. The TVL is almost half a billion and in the last 24 hours, 55 million dollars’ worth of these coins have changed hands, and that 0.3% is getting paid out to people that provide liquidity. We can add our liquidity here and earn trading fees.

What is the difference between Binance and Unit Swap? They both centralize liquidity, but the main difference is that finance takes all of the fees, whereas on a UniSwap, anyone can provide assets. This is a centralized liquidity venue. However, I can add my assets and I get the fees rather than Binance taking everything. You can add your assets by clicking “Add liquidity”, and you can take your coins and put them in the pool. You also keep complete ownership of your coins because you can take them out at any time and you have custody of the liquidity provider tokens and your own tokens through your wallet getting linked up. That’s the key difference. So with UniSwap they don’t take your fees, but with Binance they do. They take all of your fees, but we can get the fees by adding them into Uni Swap.

How much can we earn in crypto liquidity pools?

So, how much can we actually earn from providing liquidity and how does that work? It’s actually different depending on which coins that you use, which exchanges, and which liquidity pools because obviously the more trade the better and so you want to go and find the best liquidity pools to do this. When we look at pools, what we need to do is go to the best venues. Each chain will have a decentralized exchange that is the top exchange with the most volume.

So if you want to use something like that, you can go to the pool section, so this is Trader Joe on Avalanche. You can also look at PancakeSwap over on Binance smart chain, but they all do basically the same thing, so allow you to put your tokens in. You can see each liquidity pair right here. If we look at how much the liquidity is, how much the trade is, and then even if the fees are paid, we can see that $50,000 a day is getting paid to liquidity providers in this pool. That works out at about 17.5% yield. The liquidity pool USDT vs. BNB um trading around 54 million and the LP reward around 14, which is great. If we come down to a stable coin pair, you’re looking at a much lower rate of about 2.23%.

So why are there different percentages? Well, that comes down to risk essentially, and the riskier an asset is, the more you have to get rewarded for providing liquidity. This also ties into something called impermanent loss, which I’ll go through right now. It’s pretty complex. It’s really important when providing liquidity, but basically, there are two different ways you can add liquidity.

Impermanent loss

You can add liquidity with stable coins. So, liquidity with risk assets is very different. The impermanent loss is when you add risk assets to a liquidity pool. You get this thing called lot impermanent loss, which is a change in the price from when you deposit the assets into the pool to when you take them out.

If the ratio changes, which it probably will if they’re risk assets, because the price will change as people trade. You will suffer this thing called impermanent loss and that will take away from the profits that you make. Now this is just something we have to deal with. It’s not a massive deal dependent on the coin. But of course, the more risky the more that they move, the more you will suffer a permanent loss and so the higher the yield you have to get from those trading fees.

You will lose money when you withdraw the assets if the price changes. If the price is exactly the same when you put them in and when you take them out, there is no impermanent loss. You get zero. So obviously if you have stable coins like US dollar versus US dollar. You can do that because there are different versions of stable coins. You have USDC and USDT, both valued at a dollar, or we would hope so. Then they will obviously be the same when you put them in and when you take them out. There is no impermanent loss. So fees are going to be way lower because you’re just taking less risk.

If you put in two crazy small alt coins that can change dramatically, then you’re going to suffer a huge impermanent loss. So when we’re adding tokens into a pool, what you need to do is take the trading fees that you get as a percentage minus that from the impermanent loss. That is either your profit or potentially your loss. You can actually go and work this out now.

The thing that we obviously don’t know is how much the price of the tokens will change from when we put them in to when we take them out. That’s unknown, and so that’s obviously more risky. You can go to an impermanent loss calculator and try and work that out. For example, if you have token A and that comes in at $1 and token B, that was, uh, $10 right, so token B takes $10 of A to buy B.

That’s when you put them in. The price changes over time. Token A actually gets a little bit more expensive, so it doubles in price, but token B gets crazy expensive. You know, there’s something that happens, and let’s say it goes up to $200, you can see you’d actually lose 42.5% when you take your tokens out versus just holding them and not putting them in the pool.

That’s not good. To make up for this permanent loss, you would have to earn at least 42.5% in trading fees, but if it only changes from $10 to say $12, you only make a 3% in permanent loss, so you would think that you would make more in trading fees.

When we come to, you know, a liquidity pool, what we’re really looking for are assets that are very mature and won’t change much, usually yield less, and assets that are very small and kind of risky assets that change a lot in price. This one is going to see a huge yield, but the impermanent loss is probably going to be pretty big as well.

[This article is a transcription of a video made by MoneyZG]

Original video: https://youtu.be/QtiMbJt9F1U ]