Pools

What are liquidity pools??

Liquidity pools are a reserve of tokens locked on a given platform. These funds have been contributed by users, so that said platform can develop functions related to decentralized finance (DeFi); mainly the exchange or swap of cryptocurrencies..

By liquidity we understand the availability of a certain financial asset. Thus, liquidity pools serve to facilitate trading. Normally, for the exchange of any asset the intervention of a market maker is necessary. Market makers without a group of entities that favor liquidity and ensure the proper functioning of the market..

However, DeFi protocols are characterized by the fact that no intermediary or central authority is involved. Users interact directly with each other and exchange financial services through smart contracts. Thus, an automated market is created..

A decentralized cryptocurrency exchange (DEX) works through an algorithm called Automated Market Maker (AMM). That is, it is an automatic market maker, based on a smart contract. But for the DEX to work, it is necessary for the users themselves to provide liquidity. For this reason liquidity pools are created..

How does a liquidity pool work??

Any user can become a liquidity provider on a DEX. It is simply enough that you have crypto assets in your possession and lock them in the protocol through a smart contract. However, each liquidity pool is made up of two types of cryptocurrencies, which make up a pair for the exchange between them. For example ETH/BTC (Ethereum and Bitcoin)..

The user who intends to become a liquidity provider for this pair of cryptocurrencies must contribute the two cryptocurrencies to the pool in an equivalent amount. If, for example, 1 Bitcoin is exchanged for 10 Ethers, the user can contribute these amounts, multiples or fractions of them. The important thing is that it maintains a 50/50 equivalence ratio between one asset and the other when contributing funds to a liquidity pool. Otherwise, the protocol will indicate that there is an error and we will not be able to carry out the operation..

In this way, any other user can exchange Bitcoin for Ethers. Depending on the supply and demand of the pair's cryptocurrencies, the AMM will be in charge of adjusting the exchange rate. If there was no liquidity pool for a certain pair of tokens, the exchange between them could not be carried out on the DEX. Similarly, the more liquid a cryptocurrency pair has on an exchange, the less slippage it will be..

What are the risks of liquidity pools??

In principle, any user can withdraw their assets from the liquidity pool whenever they want. However, every time a cryptocurrency or token swap occurs on a DEX, the supply of one of them increases while the supply of the other asset pair decreases. That is why the Automated Market Maker adjusts the price..

In this way, at the time of making the withdrawal of funds, the protocol does not return the same portion of tokens that the liquidity provider contributed in its day (50/50). Different percentages are obtained, depending on how supply and demand have behaved. The problem is that the value of the tokens fluctuates over time. Consequently, you can get a larger amount of an asset that has fallen in price, while you get a smaller amount of tokens from one that has appreciated. The result can be an economic loss compared to simply holding the assets. This risk is called the 'impermanent loss'..

For this reason, in addition to the technical risks that may exist, it is necessary to calculate if the rewards obtained cover the possible loss of value of the tokens received when the cryptos are withdrawn from the liquidity pools..