What Is Liquidity Pool? – 4 Key Factors To Consider Before Choosing One To Invest In!

In today’s post, we’ll discuss in detail what a “Liquidity Pool” is and its importance to users investing in decentralized exchanges (DEX).

Having your assets in form of crypto is all techy and cool, but how do you convert your crypto to other forms like fiat for use in the real world without having to sell?

This is where the term “liquidity” comes into the discussion.

We’ll also look at how to earn extra income by investing in a liquidity pool, factors to consider before investing, and some popular liquidity pool providers.

Before we take a dive into the pool, let’s quickly look at the key points that make up this post:


Key Points

  1. What Is Liquidity Pool?
  2. How Does Liquidity Pool Work?
  3. Pros and Cons
  4. Popular Liquidity Pool Providers in 2022
  5. Factors To Consider Before Choosing Liquidity Pool To Invest In
  6. Conclusion

Let’s get started already!


1. What Is A Liquidity Pool?

A liquidity pool in crypto refers to a collection of tokens or digital assets locked in a smart contract that provides essential liquidity to decentralized exchanges.

They play a large part in creating a liquid decentralized finance (DeFi) system.

Working with smart contracts (which are computer programs for specific tasks such as this), liquidation becomes faster and more efficient.

In traditional finance or centralized crypto exchanges, liquidity is provided by buyers and sellers of an asset, while DeFi relies on liquidity pools to function.

Since assets are already being stored in the pool, you do not need a buyer for your asset before you can liquidate them.

Liquidity pools are used not only by decentralized exchanges to swap tokens, but also for borrowing and lending activities.

They are also essential for yield farming and blockchain-based online games.

Now, we know what a Liquidity pool is. But, how exactly do they work?

More details are in the next section.


3. How Does Liquidity Pool Work?

A typical liquidity pool rewards its users for staking their digital assets in a pool.

Rewards can come in the form of crypto rewards or a fraction of trading fees from exchanges where they pool their assets in.

Key components involved in the workings of the liquidity pools include Liquidity Providers (LPs), Automated Market Makers (AMMs), and Liquidity Provider Tokens (LPTs).

Liquidity providers (LPs) are those people who add funds to a crypto liquidity pool. They are also known as market makers.

Automated Market Makers (AMMs) is a protocol that uses a mathematical formula for pricing assets rather than through a traditional market of buyers and sellers.

Liquidity Provider Tokens (LPTs) or LP tokens are tokens issued to liquidity providers on a decentralized exchange (DEX) that runs on an automated market maker (AMM) protocol.

LP tokens are given to liquidity providers (LPs) as a reward. These are a fraction of fees and incentives, equivalent to the amount of liquidity a provider supplies after a certain amount of time.

SushiSwap (SUSHI) and Uniswap are common DeFi exchanges that use liquidity pools on the Ethereum network containing ERC-20 tokens.

Everything so far sounds fine and good. But, as with every other thing in life, there are advantages and disadvantages.

That brings us to the pros and cons of liquidity pools.


4. Pros and Cons of liquidity pools

Pros

  • They simplify DEX trading by performing transactions at real-time market prices.
  • Allows people to provide liquidity and receive rewards, interest, or an annual percentage yield on their crypto.
  • Uses publicly viewable smart contracts to keep security audit information transparent.

Cons

  • The locked assets are under the control of a small group, which is against the concept of decentralization.
  • Risk of frauds such as rug pulls and exit scams.
  • Risk of hacking exploits because of poor security protocols, causing losses for liquidity providers.
  • Exposure to impermanent loss. This is when the price of your assets locked up in a pool changes and creates an unrealized loss, versus if you had simply held the assets in your wallet.

Now, let’s head over to the next section as we look at a list of some notable crypto liquidity pool providers in the space.


5. Popular Liquidity Pool Providers in 2022

Below are popular platforms that center their operations on liquidity pools.

  • SushiSwap – A software running on Ethereum that seeks to incentivize a network of users to operate a platform where users can buy and sell crypto assets. SushiSwap uses a collection of pools to achieve this goal.
  • Uniswap – This platform allows users to trade ETH for any other ERC-20 token without needing a centralized service. It is an open-source exchange that lets anyone start an exchange pair on the network for free.
  • Curve Finance – A decentralized pool for stablecoins based on the Ethereum network. It provides reduced slippage because stablecoins aren’t volatile.
  • Balancer – A decentralized platform providing a few pooling options such as private and shared liquidity pools offering catered benefits for its liquidity providers.
  • Bancor – Ethereum-based platform using algorithmic market-making methods for leveraging pooled liquidity.
  • DeversiFi – Decentralized, non-custodial liquidity pool powered by STARKEX smart contract.
  • KeeperDAO – Ethereum-based DaFi protocol, serving primarily in the role of an on-chain DeFi underwriter.
  • Kyber Network – Ethereum-based on-chain liquidity protocol, which empowers dApps for providing liquidity
  • OIN Finance – New liquidity pool with a focus on multiple DeFi services.

6. Factors To Consider Before Choosing Liquidity Pools To Invest In

Making a decision about something with options isn’t always that easy sometimes.

Below are some of the things to consider while making a choice of the liquidity pool to work with.

1. Daily trading volume

Since you are being paid a percentage from each swap, more swaps mean bigger profits.

By looking at the trading volume histories of the platform, you can see how many trades have taken place and make an informed decision about whether that will continue.

2. Existing Liquidity

With liquidity, everything is not always as it seems.

The long-term health of a pool should align with your own goals.

For example, if you envision a robust future for a liquidity pool, being an early liquidity provider and not having to share DEX rewards could be a huge boon.

Of course, there are risks to this approach, so make sure you have good reasons to add liquidity to a pool that’s perhaps smaller than others.

3. Harvest Health Ratio (HHR)

This is a new concept introduced by Single Finance.

This indicates the harvest healthiness of the pool based on 30-day annualized rates.

The higher the HHR, the heavier the weight of the trading fees and yield farming components in the total return.

The yields from the pairs with higher HHR are usually more long-term and sustained.

4. Token price divergence within a pool

Impermanent loss is the difference between simply holding a crypto token yourself in comparison to providing liquidity for the crypto token.

The loss only occurs when a liquidity provider withdraws the Liquidity Pool (LP) tokens.

An LP may still yield a profit after withdrawing LP tokens.

However, if an impermanent loss occurs, the profit would have been higher if they had just held the tokens in a wallet.

Common ways are avoiding volatile pairings and being cognizant of how much trading fees can offset the impermanent loss.

This is where we take a break for today. Let’s conclude this post below.


7. Conclusion

Thank you for following up till the end. Hope it was worth your time.

We saw that with a liquidity pool, you can cash out your assets anytime without waiting for a buyer.

You can also invest in it as a provider and be rewarded.

Now, let’s talk:

Have you used a liquidity pool before? What was your experience?

Do you know of any liquidity pool provider that should make my list?

Let me get your response in the comment box below.

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Remember to check back for our latest posts, and as always, invest wisely.


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