Liquidity pool: what is it?

Liquidity pool what is it

A liquidity pool is a reserve of tokens freely deposited in a decentralized exchange (marketplace) such as Uniswap, by simple individuals, so that it is possible for others to buy these tokens. To better understand the purpose of a liquidity pool, we need to go back to the basics of DeFi or decentralized finance. The first decentralized exchange (DEXDecentralized Exchange), Uniswap, appeared in November 2018. In principle, such an exchange (marketplace) is not tied to a particular company that will inject funds into its operation.

The difference between a classic exchange and a decentralized exchange

On a traditional exchange such as Coinbase, if a user wishes to buy XTZ (Tezos), he can expect this exchange to offer it to him — from the moment Coinbase has hosted this cashthis platform ensures that it has a reserve of XTZ available at all times, which it can therefore sell to its users.

On a platform of Challenge such as the Uniswap exchange or the Compound lending platform, everything works automatically thanks to “smart contracts”. People must therefore agree to supply these platforms with crypto-assets.

A pair of crypto-assets of equal value

The principle, which was adopted on Uniswap and taken up in many other platforms, is therefore that of the liquidity pool. An investor agrees to “staker” (block) a pair of cryptoassets. In fact, a “pool” is a pair of two crypto-assets that can be exchanged for each other and that you agree to deposit without touching them for a certain period. They must be of equivalent value (50/50) at the time the pool is created.

An example of a liquidity pool would be to place in Uniswap, ten ETH and their equivalent in USDT (i.e. 31,200 USDT in September 2021). One who agrees to provide such liquidity is called an LP (liquidity provider – liquidity provider). Or, an LP could decide to place a reserve of BNB and Shibas in Uniswap, with each pair representing the same value. Others will then be able to buy some of these BNB or Shibas.

In a way, LPs lend these crypto-assets to Uniswap. In return, they get a commission. So every time a trade takes place on Uniswap that involves any of the cash involved, the LP collects 0.3% of the trade. Moreover, if one of the two stocks sees its value increase reasonably, for example in the case of the pair ETH / USDT, if the price of ETH increases, the LP has a good chance of being a winner when he withdraws his cash pool.

Whoever creates the liquidity pool benefits from other advantages specific to DeFI. Thus, he can make his investment without having to prove his identity. It does not have a high commission to pay to the platform as can be the case on Coinbase. Also, yields are usually high. In contrast, liquidity pools are subject to a specific risk called theImpermanent Loss which means that, in certain situations, the LP will earn less than it would have earned if it had not created this pool.

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