TheCryptoUpdates
Crypto

How do Liquidity Pools Work?

What are liquidity pool in crypto? This is a question that often confuses newcomers to the world of decentralized exchanges (DEXs) and automated market makers (AMMs). In this guide, we will break down the uses of liquidity pools and how they are used on DEXs. We’ll also take a look at some of the best liquidity pools available today.

Liquidity pools in Crypto – Easy explanation

In the traditional financial world, when you want to buy or sell an asset, you need to find someone who is willing to trade with you. This can be done through a broker, on a stock exchange, or in any other way.

In the world of decentralized finance (DeFi), there are no intermediaries like brokers or exchanges. Instead, trades are made directly between two parties using smart contracts on a blockchain. These smart contracts are called automated market makers (AMMs).

AMMs use something called a liquidity pool to facilitate these trades. A liquidity pool is a collection of cryptocurrencies or tokens that are locked in a smart contract. The size of the pool depends on how much capital has been deposited by users.

Liquidity pools in Crypto – Technical explanation

Now that we have a basic understanding of how liquidity pools work, let’s take a look at how they work from a technical perspective. What is a liquidity pool in crypto is not too difficult to grasp, as we shall proceed to show.

As we mentioned earlier, liquidity pools are made up of cryptocurrencies or tokens that are locked in a smart contract. When someone wants to buy or sell an asset on a DEX, they will use the AMM to find a counterparty and execute the trade.

Pic1: https://pixabay.com/photos/bitcoin-blockchain-crypto-3132574/

The AMM will then take a small fee for facilitating the trade. This fee is typically between 0.25% and 0.30%. The rest of the capital in the pool is used to buy or sell the assets on behalf of the users.

This system allows trades to be made in an automatic and permissionless manner. Anyone can deposit assets into a liquidity pool and start trading.

So, how do you choose the best liquidity pool? Let’s take a look at a few factors to consider.

The best Liquidity pools – Considerations

When choosing a liquidity pool, there are a few things you should keep in mind.

  • Firstly, you need to make sure that the pool is large enough to provide adequate liquidity for your needs.
  • Secondly, you need to consider the fees charged by the AMM. As we mentioned earlier, most AMMs charge between 0.25% and 0.30% for each trade.
  • Thirdly, you need to make sure that the pool is well-capitalized so that it can withstand any sudden changes in the markets.

Pic2: https://pixabay.com/photos/leather-wallet-business-cards-visa-3080553/

Here are a few of the best liquidity pools available today:

Bancor Network

BNT is an Ethereum-based token that powers the Bancor Network. The users are able to convert different assets in a decentralized manner, which is beneficial for everyone. 

BNT charges a 0.25% fee for each trade. The minimum deposit is 0.01 BNT and the maximum is 100 BNT.

The pool is well-capitalized and has a daily volume of over $100 million.

Kyber Network

Kyber Network is an on-chain liquidity protocol that allows users to convert between different assets in a permissionless and decentralized manner.

Kyber Network charges a 0.25% fee for each trade. The minimum deposit is 0.01 ETH and the maximum is 100 ETH.

The pool is well-capitalized and has a daily volume of over $50 million.

Balancer

Balancer is a protocol for automated market making on Ethereum. It allows users to trade between different assets in a permissionless and decentralized manner.

The fee when you are using Balancer is 0.30 for each trade. The minimum deposit is 0.01 ETH and the maximum is 100 ETH.

The pool is well-capitalized and has a daily volume of over $25 million.

Uniswap

Uniswap is one of the foremost entries in a liquidity pools list, especially considering its trading volume. The decentralized ERC-20 token exchange offers support for pairing Ethereum contracts and ERC-20 token contracts in a 1:1 ratio.

Fees on Uniswap are variable and depend on how much trade volume the pool has. For example, if the pool has a lot of trade volume, the fees will be lower.

The minimum deposit is 0.01 ETH without a maximum limit.

The pool is well-capitalized and has a daily volume of over $500 million.

Liquidity Pool Risks

There are risks to everything in life, but people often connect risks with cryptocurrency for several reasons. First and foremost, the main risk of crypto liquidity pools is called impermanent loss. What impermanent loss implies is the negative change of the cryptocurrency’s flat value over time.

The value of your cryptocurrency will not remain flat the entire time – cryptocurrencies are prone to change when it comes to their monetary value. The more “coins” or “tokens” you possess, the bigger the change will be.

Let’s say that you have 100 of any cryptocurrency worth $1 each in a liquidity pool. In the course of one month, the price of your cryptocurrency decreases by 5%. You will still have 100 cryptocurrency, but its total worth will be $95 after the value drop, and not $100. The same goes if the value rises by 5% – you will have 100 “tokens” or “coins”, but you could sell them for $105 instead.

This occurs when the price of the cryptocurrency changes after you have deposited it. 

Pic3: https://pixabay.com/illustrations/bitcoin-coins-virtual-currency-4207418/

Smart Contract Risks

Smart contract risks are omnipresent, but they never happen. The liquidity pools are not being regulated by a person, but by a smart contract, which implies that a bug in the system could very well result in losing everything from the liquidity pool.

Fortunately, investing in liquidity pools has little to almost no risk of smart contract issues. Dealing with cryptocurrency is serious business and the regulations around liquidity pools is quite professional. There is still risk involved, but risks are always present around us no matter what is in question; it is only up to us whether or not we are willing to take them.

Is Investing Crypto Into Liquidity Pools Worth It?

Investing crypto into liquidity pools is definitely worth it when you are trying to sell your crypto for profit or planning to trade some of your crypto for goods/services or something else. This way, you will be able to trade your crypto at any given moment and you’ll even have lower fees due to how AMMs function.

Liquidity pools follow the simple supply/demand economics. When any user purchases a set amount of “coins” or “tokens” from a liquidity pool, the number of “coins” or “tokens”, normally, decreases. Thus, their value increases. In short, the more people purchase a specific token, its price will go up since there will be less in supply and the demand will be higher.

If you understand how this functions, investing crypto into liquidity pools might be worth it for you. Not only will you be earning a profit, but the price of your remaining crypto will also rise, provided that you only sell/trade a part of it. You could be earning money from both trading and from the general influx in prices due to how liquidity pools function. In other words, if you learn how to profit from liquidity pools, you won’t regret it.

When Should You Start Investing?

We highly recommend that you learn everything you need to learn about crypto before you start investing into it. You can make money from liquidity pools if you know how to do it. For this, you might need to understand all the pros and cons of liquidity pools. We have basically covered them, but let us review them:

  • Pros. You can earn a profit from selling, depending on the number of coins in the liquidity pool; the trade fees are low (around 0.25%) so you can trade while using better prices; if you are aware of the risks, you can turn that into your own advantage.
  • Cons. You can lose money on impermanent loss (when the value of the crypto decreases by a certain percent while in the liquidity pool), the smart contract risks are also present, albeit chances of them ruining your investment plans are close to zero.

Pic4: https://pixabay.com/photos/money-profit-finance-business-2696228/

If you carefully consider all options you have, you should be able to earn money from liquidity pools. Despite the pros and cons, there are some liquidity pools in 2021 you should definitely check out. Even if you didn’t start with investments yet, learning more about how they function, how they change on a daily/weekly basis and what is the supply and demand could get you a long way in the investment world. All you need to do is learn how do liquidity pools make money, and you’ll be on the right track. 

Is it Hard to Get Into Investing? 

Every beginning is hard and it can get harder as the time progresses. For as long as you keep your goals in check and try to make the most out of your situation, you will be able to learn everything and get into everything. Investing is nothing different to that.

What some people do is follow the cryptocurrency trends and decide when exactly to get into the investing business. The key is to understand that there is no such thing as “too early” or “too late” and that you can make a decent profit from your investments at some point in the future.

So, getting into investing is not hard, but it is also not necessarily easy. For as long as you have a good investment strategy and you follow it through, you should be able to do it without any significant issues. Starting by learning about liquidity pools is a good start as any.

Conclusion

We hope that this guide has helped you learn are liquidity pools worth it. When choosing a pool, make sure to consider the factors we mentioned earlier so that you can find the best one for your needs. Being informed will help; random google searches might not always yield viable results, and by following TradeCrypto for regular information about liquidity pools, you might stay a step ahead. Thanks for reading! We hope this guide was helpful in understanding how liquidity pools work and how they are used on DEXs.

Related Articles

Michael Saylor is Concerned About the New Proposed Regulation of Bitcoin Energy in New York

Inverse Finance, a lending platform based on Ethereum, got hacked

Mridul Srivastava

Solving the Problems of Crypto Mining: The GoMining Use case

Ahmad