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Liquidity pools play an important role in yield farming. To better understand how liquidity pools work, we will explain what liquidity pools are, what the mechanism is behind them and what to take in account before investing in liquidity pools.
Liquidity pools (LP) are pools of tokens that are managed by smart contracts. Because decentralized exchanges (DEXes) do not provide liquidity themselves, investors are needed to deposit their tokens into pools to provide liquidity for token pairs. This allows traders to swap between the tokens from the token pairs. In essence, liquidity pools are the trading aspect of a decentralized exchange.
A liquidity pool always contains two or more tokens. Each liquidity pool creates a market for the assets in the pool. Cake/BNB is a good example of a popular liquidity pool at the DEX Pancakeswap.
Liquidity pools can be created via a DEX, if one does not yet exist for a specific token pair. To do so, liquidity providers must add both token contract addresses and deposit these tokens into the liquidity pool. DEXes aim to maintain liquidity pools with a token ratio of 50/50. This means that in our Pancakeswap example, liquidity providers will have to deposit the same value of CAKE and BNB into the liquidity pool.
After the liquidity provider has deposited his tokens into the pool, he will receive an amount of LP tokens in return. These tokens are the receipt of the deposit. Make sure you don’t lose these LP tokens, as they are needed to withdraw your assets from the liquidity pool. Every time a transaction (read: swap) is made in the liquidity pool, a certain percentage (usually 0.3%) goes to the LP token holders.
Using a deterministic price algorithm, any token swap within a liquidity pool will result in a price shift. This algorithm is also known as an automated market maker (AMM).
A constant commodity market maker algorithm is used for basic liquidity pools such as the one used by Pancakeswap, which results in the amounts of the token pair remaining the same. This algorithm allows liquidity pools to maintain their liquidity, regardless of the size of the trades. The reason for this is that as the target amount increases, the algorithm increases the price of the token asymptotically.
The main reason liquidity is so important is because it largely determines how the price of an asset shifts. In a low liquidity market, a relatively small amount of open orders will be open on both sides of the order book. This results in a significant price shift, making the asset unpredictable and unattractive. Due to this reason, liquidity pools are an important part of the decentralized finance (DeFi) revolution.
Currently, there are two types of decentralized exchanges in the DeFi space:
Suppose an investor wants to provide $200 of liquidity in the Cake/BNB (50/50) liquidity pool. Because the investor wants to deposit $200, he will need to have $100 in BNB and Cake tokens: After all, it is a 50/50 liquidity pool.
After the investor (also called liquidity provider) has deposited his assets, he will receive LP tokens in return. These tokens reflect the value of the investor’s investment + the extra trading fees that is earned from the liquidity pool. When the investor wants to withdraw his assets from the liquidity pool, he has to return the LP tokens.
Every time a trader executes a token swap in the Cake/BNB liquidity pool, a trading fee is charged. As mentioned before, this fee is around 0.3% on most DEXes. Suppose the investor has a 10% share of the liquidity pool: in total there is $2000 dollars in the liquidity pool and the investor’s share is $200. When a trader swaps a token, the investor receives 10% of the 0.3% trading fees in the liquidity pool. The trading fees are paid in both Cake and BNB.
Liquidity pools have several advantages over traditional exchanges:
Keep in mind that various risks may arise when providing liquidity in a liquidity pool and it is possible to lose your assets. The most important risks are:
Before you start providing liquidity to liquidity pools, it is important to understand exactly how impermanent losses work.
Suppose an investor has deposited $100 of Cake and $100 of BNB tokens into a 50/50 liquidity pool on Pancakeswap. This means that the investor has a token ratio of 6.80 Cake ($100) and 0.31 BNB ($100). After the deposit, the ratio between the tokens and the prices of the tokens changes, which is caused by market volatility and trading. This results in, that at a given moment, there is more Cake than BNB in the liquidity pool or the other way around.
If the investor chooses to withdraw his tokens from the liquidity pool after a change in token ratios, he may receive more Cake than BNB: for example 7.50 Cake and 0.28 BNB. If the price of BNB has gone up during this period, this will result in the investor’s impermanent loss becoming permanent.
To clarify how impermanent losses work, let’s use an example where we compare profits from the liquidity providing of Cake and BNB versus HODLing the assets. Let’s say the investor has deposited $200 worth of Cake and BNB into a liquidity pool on Pancakeswap. Suppose the price of BNB has increased from $317 (at purchase) to $600 (after providing liquidity and shift in the ratio Cake to BNB):
According to the calculation, the investor would have earned $8 extra profit from HODLing. The investor has two options, should he have chosen to provide liquidity:
Because trading fees help to reduce the impact of impermanent loss, it is important to take a good look at the APY’s of liquidity pool. The higher the APY, the less likely you will exit the liquidity pool with a permanent loss.
Liquidity pools play a significant role in DeFi. They allow investors to trade tokens while providing liquidity providers with the opportunity to generate transaction fee profits. Investors do not have to meet certain requirements to provide liquidity in a pool. Thanks to easy-to-use platforms such as Pancakeswap, novice investors can easily start providing liquidity or swap tokens from the various liquidity pools.
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