Liquidity Pools in Cryptocurrency

September 8, 2021

What is a Crypto Liquidity Pool?

A crypto liquidity pool refers to funds that are locked inside of a smart contract. These funds are used on decentralized exchanges to facilitate the trading of digital tokens.

How do Crypto Liquidity Pools Work?

Liquidity pools allow for a trade to happen based on the amount of liquidity available, rather than needing another user to agree on a trade price. In traditional trading, order books are used to match buyers and sellers. Because both have to agree on a price, it can mean that sometimes assets are sold at unfair prices.

This system is helpful for trading ETH for USD, for example. Liquidity Providers (LPs) add funding to the pool and then receive income based on trades that happen in pools in which they’ve added those funds. The amount is based on the proportion of liquidity added by the LP.

Anytime trading occurs with a smart contract there is a gas fee. This cost can fluctuate which doesn’t allow for the traditional market maker role, as they would lose money trying to change their price to match the current market price of an asset.

Liquidity pools hold two different tokens and creates a new market based on these two digital assets. While the first Liquidity Provider (LP) sets the price for the assets, each token swap changes the price based on an algorithm set by the Automated Market Markers.

How do you Join a Cryptocurrency Liquidity Pool?

Anyone can join a liquidity pool, and accessibility is a driving factor in their success. While platforms such as Uniswap made the concept popular, there are also other protocols that use the practice.

You’ll need a wallet that includes ETH, as well as the ERC20 token you wish to pair against. After you’ve added liquidity to the pool you’ll receive LP tokens, which entitle you to a percentage of the transaction fees.

What is the Best Liquidity Pool for Crypto?

Cryptocurrency is still a relatively new market and there are new platforms and protocols being built to help facilitate a better trade process.

Currently, the best liquidity pool is Uniswap, because of its ability to easily support 50% Ethereum contracts and 50% (ERC20 token) contracts. Curve finance is also a great liquidity pool due to its focus on stable coin trading.

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Liquidity Pool FAQ’s

1. What is Dark Pool Liquidity?

Dark pool liquidity refers to private exchanges that are set up to exchange securities without public knowledge. Because these trading venues are hidden, they often support larger investors rather than those who trade with transparency.

2. What is an Alternative Liquidity Pool?

Alternative liquidity pools are another way of referring to dark pools. These have been set up to allow banks and investors to trade large amounts of shares anonymously.

3. What is a Defi Liquidity Pool?

Cryptocurrency is decentralized finance (Defi). Defi liquidity pools are when a smart contract includes a certain amount of tokens and uses this liquidity to support trading.

4. What are Liquidity Pool Tokens?

Liquidity pool tokens are provided by Liquidity Providers (LPs) to ensure that trading can occur without a buyer being present in the market. LPs receive a portion of trading fees anytime tokens are swapped inside of their liquidity pool.

5. How are Liquidity Pool Tokens Calculated?

The initial LP sets the prices of the assets in the smart contract. They also receive passive income based on the percentage of tokens that have places in the pool. Automated Market Makers calculate new prices based on trading that takes place within the pool. AMMs are done with a mathematical algorithm, helping to reduce market manipulation that occurs with traditional market makers.