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Blog|Defi|Guide on Liquidity Pools to Use In 2022
Published April 26, 2022|7 min read

Guide on Liquidity Pools to Use In 2022

Liquidity is an important part of every market, as it defines how easy and efficient it is to trade assets. While liquidity in traditional markets is ensured by certain organizations, crypto markets are decentralized and require new solutions. This is where liquidity pools come to play. What is a liquidity pool? It allows crypto traders to perform any transactions conveniently, and we are going to explain how it works.

What Is a Liquidity Pool?

Many beginners on crypto markets want to get a liquidity pool explained. A liquidity pool is a smart contract stored on a blockchain that holds various assets. The more assets are included in a liquidity pool, the easier and quicker each trade becomes. Crypto markets usually have low liquidity, as no central authority or organization behind them would ensure a decent level of liquidity. This is why liquidity pools are created with the help of crypto community members.

Why Use Liquidity Pools

Is a crypto liquidity pool truly necessary for the functioning of crypto markets? It is safe to say that they are highly important for a few reasons.

Facilitate the Trading

As cryptocurrencies are not as liquid as fiat currencies, it is much more difficult to trade tokens on crypto exchanges. Liquidity pools are crucial to creating the necessary liquidity that allows trading easily without having to wait for another trader who will accept your terms.

Advantages of Using

There are multiple advantages for both traders using liquidity pools and market makers contributing their tokens to a smart contract. All users can trade without slippage, which occurs when there is low liquidity. The longer your trade continues, the bigger slippage will be observed. With liquidity pools, it becomes possible to trade swiftly and cost-effectively. Those who donate their assets to liquidity pools also receive benefits in the form of passive income. As each trade comes with a small fee, this money is distributed among all the donators.

One thing about liquidity pools is that everyone can contribute to them regardless of their experience. Even newbies in crypto trading and NFT minting can easily use liquidity pools to their advantage. There are numerous opportunities available for more advanced users. All investors to a liquidity pool can receive governance tokens and partake in important decisions regarding these pools.

How Do Liquidity Pools Work

To fully understand the importance of a liquidity pool, it is necessary to find an answer to the question: How does a liquidity pool work? For example, if a specific pool trades Ethereum for USD, it is necessary to have a stock of these assets so that everyone can trade their tokens immediately. Liquidity providers are those people who store their assets in the pool, creating the required opportunity for exchanging money. In return, they receive passive profit, various rewards, and liquidity tokens. There are special protocols called AMMs or automated market makers, which correct prices based on supply and demand. The latest platforms with liquidity pools have more flexibility in improving fee systems by changing the pricing algorithm of underlying protocols on the blockchain.

Why It Is Important

The liquidity pool meaning implies that exchanges need to have enough assets stored in their liquidity pools because people simply would not be able to complete their trades otherwise. Long trades result in increased slippage, which means the prices keep changing and often against the trader.

Popular Liquidity Pools

There are different types of liquidity pools serving various markets. Actually, liquidity pools are suitable not only for cryptocurrencies nowadays, and their functionality continues to expand as new solutions emerge.

NFT Pools

What is a liquidity pool in NFT markets? NFTs, or non-fungible tokens, are currently on the rise all over the crypto community. They are usually digital pieces of art that exist in one copy, thanks to unique data embedded in them. Because they are non-fungible, the question of liquidity gets really challenging. The value of NFTs is defined completely by demand, which can fluctuate drastically. This is why NFT pools were created to increase their liquidity and facilitate trading.

DeFi Pools

Decentralized finance platforms aim to facilitate various transactions. However, they require extra support to create liquidity because of their decentralized nature. This is where liquidity pools come in handy. So, what is a liquidity pool in DeFi? They are smart contracts locking a certain amount of tokens that allow users to trade efficiently. In traditional finance, people have to use banks and other intermediaries to make financial transactions, lend money, etc. When working with a bank, a person has to go through all kinds of bureaucracy and pay expensive fees. Even digital exchanges have their own limitations. It is often difficult for buyers and sellers to agree on a price level. Smart contracts on DeFi platforms eliminate intermediaries, allowing people to trade with each other safely. In addition to improved security, the prices are also much more accessible.

Risks on Crypto Liquidity Pools

Of course, liquidity pools are still relatively new and require improvements. Several potential issues might occur when using or supplying a liquidity pool.

Impermanent Loss

This issue implies that assets stored in a liquidity pool might fluctuate in price based on supply and demand. This happens when the price of one of the traded assets rises sharply. The value of another asset might drop to the point where even delivering more assets will not fix the problem. In addition, all losses can become permanent in case the owners withdraw their assets from the liquidity pool. Only liquidity providers can save the market by covering the losses with transactional fees.

Smart Contract Bugs

An existing stack of smart contract technologies is not 100% immune to bugs and similar issues. In case there is any malicious intervention endangering a smart contract, all assets could be lost completely. One of the most striking examples of errors in a smart contract is a platform hacked in 2021 when about 11 million dollars were stolen from users.

Centralized Governance

DeFi platforms should be decentralized by nature, but in reality, a long road to complete decentralization lies ahead. Decentralization is necessary for increased safety. This way, a single person or organization cannot control a platform or market. However, some sort of centralization is still observed in DeFi. Platforms with centralized governing bodies are not immune to theft, scams, and other malicious actions performed by their developers and creators.

Fees to Pay

Various fees are involved in managing and using a crypto liquidity pool. Each user has to pay a flat fee specified by each specific platform. The fees are usually much lower than those on regular crypto exchanges, reaching only 0.2% of the trade amount or a similar percentage. These fees are necessary to keep liquidity pools running.

All market makers who contribute to liquidity pools are able to receive passive income by providing their assets. Based on the chosen liquidity pool strategy and the number of tokens put into a liquidity pool, investors receive their share of income calculated from the commissions paid by traders.

Summing Up

Liquidity pools are smart contracts running on blockchain technology. They create the necessary liquidity for decentralized trading on markets that lack liquidity as opposed to traditional financial exchanges. While DeFi platforms struggled with liquidity in the beginning, now they can create liquidity pools with the help of their community members. Instead of focusing on finding a seller or buyer on a crypto exchange, market makers contribute to liquidity pools by providing their assets. This allows all users to trade quickly and effectively without being affected by slippage.

Crypto liquidity pools offer many opportunities for liquidity providers and ensure market success. There are several ways of earning a stable passive income. One of the most popular methods known as yield farming allows simply donating assets to a liquidity pool and then gathering fees from traders who use it for transactions. There are also special projects that offer loans for traders, and liquidity providers can benefit from investing their assets as well. Overall, liquidity pools are safe and convenient solutions for trading crypto and purchasing NFTs, thanks to improved liquidity.

Frequently Asked Questions

Do I Need to Pay Any Fees in Liquidity Pools?

Yes, all traders in liquidity pools need to pay a small fee per transaction. This fee can be as small as 0.2% of the trade amount. This is necessary to keep high liquidity, as these fees are distributed among liquidity pool users who add their tokens to the pool. Thanks to them, traders can perform transactions quickly and without high fees.

What Is a Liquidity Crypto Pool?

A liquidity pool is a smart contract that holds tokens and crypto coins provided by users to make trading of various assets easier and more accessible. Liquidity pools allow trading without searching for another trader to finish a transaction, as there are assets stored in the smart contract, which are always ready to go.

Who Can Use It, And Why Do I Need a Liquidity Pool?

Liquidity pools can be used by market makers who deposit their assets, such as tokens and cryptos, in a pool for increased market liquidity. Then, these pools can be used by traders who can perform transactions without having to wait for other people on a crypto exchange. People need liquidity pools for accumulating passive income and for convenient and quick crypto trading with lower fees.