Liquidity Pool: What is a Liquidity Pool in the World of Crypto
By | Updated January 7th, 2022
What is a liquidity pool?
A liquidity pool is a collection of tokens used to facilitate crypto trading, lending, and more. The liquidity provider earns a trading fee for providing the tokens needed to make rapid exchanges possible.
Why Are Liquidity Pools Necessary?
Crypto trading typically operates on an order book model, wherein buyers proclaim the highest price for which they will purchase a token and sellers proclaim the lowest. Ideally, the buyer and seller demands would converge – but often enough, they do not.
In a traditional exchange, the liquidity required to cover the disparity in the bid-ask spread would be provided by market makers. By volunteering to always buy or sell a particular asset, market makers enable others to trade without the need for a willing counterparty.
The order book model’s reliance on multiple market makers makes it impractical for DeFi, where transactions may easily occur at a rate exceeding 500 per minute. Simply keeping their orders updated would quickly ruin a market maker who must pay gas fees!
Crypto liquidity pools solve this unique problem posed by DeFi.
How Does Liquidity Pool Work?
What is a liquidity pool? In essence, it holds two different tokens while simultaneously creating a novel market for that specific pair of tokens. When they form a new liquidity pool, the liquidity provider assigns an initial price to either of its tokens; they are incentivized to assign equal value to both.
Every time a liquidity pool facilitates a token swap, an automated market maker (AMM) utilizes a deterministic pricing algorithm to ensure that the product of the two supplied tokens’ quantities stays constant. In this fashion, the AMM ensures that a liquidity pool can facilitate a trade regardless of said trade’s scale.
It is important to note that the ratio of tokens in a liquidity pool ultimately determines those tokens’ prices. When a buyer removes a quantity of token A from the pool while simultaneously adding to the quantity of token B, the price of token A increases relative to that of token B.
This is why liquidity pools that are large relative to the trade that has taken place will incur less slippage (i.e. the price change between its two component tokens will become less pronounced).
The liquidity provider receives unique LP tokens according to the amount of liquidity they contribute to their pool. When a liquidity pool facilitates a trade or other transaction, a 0.3% fee is proportionally distributed to all of that pool’s LP token holders.
When the liquidity provider wishes to retrieve their liquidity as well as any fees they may have accrued, they simply burn their LP tokens.
The exact nature of various crypto liquidity pools may vary. But in essence, a DeFi liquidity pool enables its user to contribute tokens to a standing fund that facilitates trading. In consideration, they receive a small fee whenever their liquidity pool facilitates a trade, which they may redeem at a later point.