LIQUIDITY POOLS PASSIVE INCOME EXPLAINED
A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a Smart Contract that is used to facilitate trades between the assets on a Decentralized Exchange (DEX).
Instead of traditional markets of buyers and sellers, many Decentralized Finance (DeFi) platforms use Automated Market Makers (AMMs), which allow digital assets to be traded in an automatic and permissionless manner through the use of liquidity pools.
What is Liquidity?
The Role of Crypto Liquidity Pools in DeFi
Liquidity pools are a mechanism by which users can pool their assets in a DEX's smart contracts to provide asset liquidity for traders to swap between currencies.
Liquidity pools provide much-needed liquidity, speed, and convenience to the DeFi ecosystem.
Before automated market makers (AMMs) came into play, crypto market liquidity was a challenge for DEXs on Ethereum. At that time, DEXs were a new technology with a complicated interface and the number of buyers and sellers was small, so it was difficult to find enough people willing to trade on a regular basis.
AMMs fix this problem of limited liquidity by creating liquidity pools and offering liquidity providers the incentive to supply these pools with assets, all without the need for third-party middlemen.
The more assets in a pool and the more liquidity the pool has, the easier trading becomes on decentralized exchanges.
Why Are Crypto Liquidity Pools Important?
Whether it's a low cap cryptocurrency or penny stock, slippage will be a concern when trying to enter - or exit - any trade.
Slippage is the difference between the expected price of a trade and the price at which it is executed.
Slippage is most common during periods of higher volatility, and can also occur when a large order is executed but there isn't enough volume at the selected price to maintain the bid-ask spread.
This market order price that is used in times of high volatility or low volume in a traditional order book model is determined by the bid-ask spread of the order book for a given trading pair.
This means it's the middle point between what sellers are willing to sell the asset for and the price at which buyers are willing to purchase it. However, low liquidity can incur more slippage and the executed trading price can far exceed the original market order price, depending on the bid-ask spread for the asset at any given time.
Liquidity pools aim to solve the problem of illiquid markets by incentivizing users themselves to provide crypto liquidity for a share of trading fees. Trading with liquidity pool protocols like Balancer, Bancor, Curve, Osmosis and Uniswap for a few requires no buyer and seller matching.
This means users can simply exchange their tokens and assets using liquidity that is provided by users and transacted through smart contracts.
How Do Crypto Liquidity Pools Work?
That's why most liquidity providers earn trading fees and crypto rewards from the exchanges upon which they pool tokens.
When a user supplies a pool with liquidity, the provider is often rewarded with liquidity provider (LP) tokens.
LP tokens can be valuable assets in their own right, and can be used throughout the DeFi ecosystem in various capacities.
Usually, a crypto liquidity provider receives LP tokens in proportion to the amount of liquidity they have supplied to the pool.
When a pool facilitates a trade, a fractional fee is proportionally distributed amongst the LP token holders.
For the liquidity provider to get back the liquidity they contributed (in addition to accrued fees from their portion), their LP tokens must be destroyed.
Liquidity pools maintain fair market values for the tokens they hold thanks to AMM algorithms, which maintain the price of tokens relative to one another within any particular pool. Liquidity pools in different protocols may use algorithms that differ slightly.
For example: Uniswap liquidity pools use a constant product formula to maintain price ratios, and many DEX platforms utilize a similar model.
This algorithm helps ensure that a pool consistently provides crypto market liquidity by managing the cost and ratio of the corresponding tokens as the demanded quantity increases.
The token ratio determines the pool's price. When somebody buys DAI from the DAI/ETH pool, for example, the volume of ETH grows, rising DAI's price while reducing ETH's.
Yield Farming and Liquidity Pools
Participating in these incentivized liquidity pools as a provider to get the maximum amount of LP tokens is called liquidity mining.
Liquidity mining is how crypto exchange liquidity providers can optimize their LP token earnings on a particular market or platform.
There are many different DeFi markets, platforms, and incentivized pools that allow you to earn rewards for providing and mining liquidity via LP tokens.
So how does a crypto liquidity provider choose where to place their funds? This is where yield farming comes into play.
Yield farming is the practice of staking or locking up cryptocurrencies within a blockchain protocol to generate tokenized rewards.
The idea of yield farming is to stake or lock up tokens in various DeFi applications in order to generate tokenized rewards that help maximize earnings.
This allows a crypto exchange liquidity provider to collect high returns for slightly higher risk as their funds are distributed to trading pairs and incentivized pools with the highest trading fee and LP token payouts across multiple platforms.
This type of liquidity investing can automatically put a user's funds into the highest yielding asset pairs.
Platforms like Yearn.finance even automate balance risk choice and returns to move your funds to various DeFi investments that provide liquidity.
The RISK - Impermanent Loss
The loss is 'impermanent' because the original value of the tokens can be restored if the liquidity pool restores balance.
So in short if a token traded on a centralized exchange exploded in value the tokens in the Liquidity Pool wouldn't and this would lead to arbitrage trading draining the pool. Since tokens added to Liquidity Pools are Bonded for a certain amount of time you wouldn't be able to do anything.
The best option to protect yourself against this is to find pools made up with both tokens that you want to hold long term.