A liquidity pool in cryptocurrency markets is a deployed smart contract where tokens are locked for the purpose of providing liquidity. This may be a combination of stablecoins and required tokens that are provided for liquidity or a single provision of liquidity in the required tokens.
In other words, liquidity pools are basically funds thrown together or aggregated in a big digital pile for ease of transactions. This is done in such a way that these pools are simply a collection of tokens or digital assets that are stored in a smart contract.
When the liquidity providers have deposited their tokens into the pool, there is an associated benefit after several transactions that would ensure they are rewarded with a fraction of fees from the various trading activities, equivalent to the amount of the liquidity they have supplied.
However, there are other terminologies associated with the liquidity pool which if investors are not educated about might lead to an ignorant financial decision. Some of these concepts include but are not limited to the following:
- Automated Market Makers: This is a term used to describe liquidity providers who lock up their funds and trade them back to back in order to create buy and sell orders within the order book.
- Slippage: Slippage is the difference between the expected price of a trade and the price at which it is executed. This is usually associated with trade order execution such that it considers the time when a trader places the trade and when the trade is executed, thereby leading to either a loss or gain in value. Slippage is most common during periods of higher volatility, and can also occur when a large order is executed but there isn’t enough volume at the selected price to maintain the bid-ask spread for the execution of the trade.
- Liquidity mining: Liquidity mining is basically a system developed to enable crypto exchange liquidity providers to optimize their LP token earnings on a particular market or platform.
What about the Impermanent loss?
From an ideal standpoint, an impermanent loss is basically a net difference between the value of two cryptocurrency assets within a liquidity pool-based automated market maker system. In other words, it would involve the provision of funds by market makers in a pool facilitated by a smart contract to carry out a set of instructions to execute a trade within the system. This can happen by simply holding the assets in a cryptocurrency wallet on the part of the liquidity provider in a decentralized manner.
In reality, there are different scenarios where an investor provides liquidity to a pool, and the relative price of the deposited asset is expected to change in comparison to its initial value during the deposit. Consequently, the larger this difference is, the more the investor is exposed to the loss if the value of the tokens goes negatively downwards.
However, this can also have a positive effect on the value of the investment by the investor when the price of the liquidity provided goes positively upwards thereby making more profit for the investors.
On the other hand, a user can realize an impermanent loss only after withdrawing the funds from the liquidity pool. The impermanent nature of this loss exists because the prices of cryptocurrencies can return to their initial exchange price at any given time.
Once this happens, the loss would no longer exist because it is only permanent if an investor takes their fund back from the liquidity pool and the liquidity value has a larger difference than when it was initially deposited into the liquidity pool.
In conclusion, it is always advisable to educate yourselves as users of any platform on the best way to maximize profits on any decentralized platform or exchange when investing as a liquidity provider.
