For any centralized crypto exchange to function properly, a liquidity pool is a must, as it provides liquidity for trade.
Since the start of decentralized finance (DeFi), liquidity has become a driving force for users to adopt cryptocurrency.
One of the main reasons is that these liquidity pools are based on smart contracts that lock the liquidity provided by the users and in return the liquidity provider earns interest from centralized and decentralized crypto exchanges.
How do liquidity pools work?
Liquidity pools are the money pool. It works on an order book model. A liquidity pool is the pool of crypto assets for a pair, that users are looking to trade.
Liquidity pools are smart contracts because this is the technology that allows liquidity pools to exist.
It is nothing more than just code. It is a smart contract written as a way to hold certain funds as they do math with those funds and allow users to trade based on the math it is coded. The pool starts off at an exact ratio of 50:50.
If you want to give a pool of $1000, then you need to give $500 to token A and $500 to token B.
Why does a liquidity provider have to give 50-50? Because most of the liquidity pool used an algorithm called the constant product automated market maker.
If a user buys token A by giving token B, it will slowly raise the price of token A. Because, as you keep buying token A, the liquidity pool of token B will keep on increasing, because they want to keep the 50:50 ratio of Taken A and Token B.
For every transaction users make on the liquidity pool, users have to pay a very small percentage as charges for making the trade.
Suppose a user wants to trade his token A for another chain token C. In this case, most decentralized exchanges will connect two liquidity pools together to allow users to perform the trade directly.
Then that decentralized exchange will do two swaps, first, the exchange will swap token A with token B and token B will be swapped with the desired token, in this case, it is token C.
This is done through a routing process, which helps users to trade for any tokens, subject to the availability of the liquidity pool.
How liquidity pools create benefits
For every trade in the liquidity pool, users pay a small fee. When more and more liquidity providers join the pool, the fees they earn for providing liquidity go down.
Let us understand this with an example. Liquidity pools are always added in a pair, like KLV-USDT, KLV-BTC, and others. Suppose a user adds $500 worth of KLV and $500 worth of USDT as liquidity to the pool, in that case, if there is any trade, all the fees will go to him/her.
Imagine, if more liquidity providers join the pool and add the same worth of KLV-USDT, then any fees earned will be shared between other liquidity providers too. For example, if there is only one liquidity provider in the pool and it earns $150 as commission, all go to one, but, if there are two liquidity providers, then each provider will get $75 each.
As the pool grows the commission earned by liquidity providers goes down but provides stability to the pool.
This means how much a user can affect the prices of tokens from this liquidity pool. If the pool is small, there will be a very high price impact. In some cases, the user can even double and triple the assets. As the pool grows and becomes larger and larger, the price impact becomes lower.
If a user buys a huge amount of token A, then the prices of token B drop. At least in that pool, Token B might be lower, as compared to other exchanges.
Then in this case a user will buy token B in the liquidity pool and sell it to another exchange at higher prices and with every transaction, the user will make higher profits. This is called arbitrage trading.
Automated Market Makers (AMM)
The primary driving force behind any liquidity pool is automated market makers (AMM).
AMMs that operate automatically are designed to engage in reciprocal trading. By bridging the gap between buyers and sellers of tokens, automated market makers efficiently facilitate deals. As a result, anyone can buy or sell tokens without having to go through a lot of difficulties, such as tracking out someone else who has those tokens and wants to transfer them.
Automated market makers generate income from trading by assessing a modest commission for each transaction.
Pros and Cons of liquidity pools
- Anyone can lend money and receive a yield on the cryptocurrency they are holding.
- They simplify the process for traders to execute decentralized exchanges and spot deals at current market prices.
- LPs use smart contracts that are accessible to the public to increase the transparency of security audits.
- Not truly decentralized, as pools of funds are controlled by one person or a small group.
- By locking funds into a pool, liquidity providers are at the risk of making an impermanent loss.
- Many liquidity pools have suffered from significant security breaches due to insecure smart contracts or flash loan attacks, resulting in enormous losses for liquidity providers
Klever Exchange adding its pool soon
After the launch of its own chain, KleverChain, Klever, one of the fastest-growing crypto ecosystems, will be adding its own liquidity pool.
Imagine you have crypto assets that you are holding in your crypto exchange account, why not make crypto assets work for you and earn some income, this is what a liquidity pool does.
Liquidity pools by and large are the mechanism that helps users earn passive income from lending their crypto assets on the exchange, providing them even more financial freedom.