Liquidity Pools Explained
Liquidity pools are undoubtedly one of the most important innovations in the crypto market. Thanks to them, many coins can be offered to crypto investors by decentralized exchanges before they are listed on centralized exchanges. Thus, a high return opportunity for investors and a playground for new coins has emerged.
Liquidity pools, which are part of Automated Market Makers (AMM), were popularized by Uniswap in 2018. First of all, let's talk about what market maker means and how things worked before AMM's.
Special programs that match buy and sell orders are used on centralized exchanges. On the other hand, people called market makers are needed to ensure that there is sufficient liquidity in the market at all times. Market makers enter orders in the relevant market in a way that is profitable for them. In doing so, they provide the necessary liquidity in the market. Large institutions or high-net-worth individuals usually provide the necessary capital for this business.
AMMs have automated this process, and anyone can provide the necessary capital in exchange for the promise of return. Thanks to the liquidity pools created on Defi applications such as Uniswap and Pancakeswap, trading a token becomes possible without the need for any interlocutor. Coin exchange is made with a liquidity pool instead of a second person or market maker.
Automatic pricing in liquidity pools is done using the x*y=k equation. In this equation, x is the price of the first coin in the pool, and y is the price of the second coin in the pool. k is a fixed number. This equation states that as the price of one coin increases, the price of the other should decrease by the same ratio. Thus, the pool is always balanced to contain equal monetary amounts of the two coins.
Those who make swap transactions using liquidity pools pay a commission of 2 to 3 per thousand. There are many alternatives for frequently traded coins. You can trade by finding the most suitable rates on https://debank.com/swap. I have been using this application for a long time and I saved a lot of money.
Liquidity pools have recently become an important investment alternative for crypto investors. The reason for this is the opportunity to earn a share of the swap commissions of the relevant platform and/or the crypto of the relevant swap application, thanks to the investment made in the liquidity pools. For example, if we invest in the Steem-BNB liquidity pool on https://robiniaswap.com/farms, it is possible to earn an annual return of 77%. Thus, in addition to the increase in the value of the related cryptocurrencies, regular income is obtained.
Although liquidity pools were popularized by the Uniswap application, the Pancakeswap application is now widely used. This is because Uniswap, which operates on the Ethereum network, is subject to high transaction costs.
It is necessary to have a Metamask wallet to be able to transact in applications such as Pankaceswap or Robiniaswap. In addition, it is necessary to keep a certain amount of BNB in this wallet to be used for transaction fees. Unfortunately, not all networks offer free transactions like Steem, the transaction fee on Binance smart network is around 0.5 dollars.
There are dozens of liquidity pools on swap applications. How do we know which to invest in? First of all, we need to ask ourselves the question of whether I would buy these coins if there was no liquidity pool. We need to evaluate the price potential of the coins to be invested, as well as the rate of return of the liquidity pool.
• Real-life use or potential use
• Market value ranking
• Inflation rate
• Value against Bitcoin and Ethereum over time
should be considered. We can reach the inflation rate of the main cryptocurrencies on https://messari.io/screener/340B7D0D.
The rate of return of liquidity pools can change frequently for reasons such as the price change of the coin awarded, the amounts deposited and withdrawn into the pool. Therefore, I want to emphasize again that the main thing is to invest in the right coins.
One or both of the cryptocurrencies in liquidity pools can be stable coins. This diversity allows us to make different choices when our market prospects are optimistic, neutral, or pessimistic.
If we have optimistic views about the market, we may prefer to take full advantage of a possible rise by choosing a cryptocurrency pair that does not contain stable coins.
If we are neutral about the market, we have been affected less by a possible price drop by investing in a coin-stable coin pair. Moreover, such liquidity pools provide a higher rate of return compared to pools containing my coin-coin pairs.
If we have pessimistic views about the market, we can get an annual return of 8-9 percent with minimum risk by investing in a stable coin pair.
In this article, I gave information about liquidity pools, one of the important elements of the Defi. You can access more information on the subject through my previously published articles listed below.
Introduction to Defi - 1
Introduction to Defi - 2
Investing In Liquidity Pools: Opportunities & Pitfalls
Extra Gains and Impermanent Loss on Liquidity Pools
5 Yield Farming Methods of DeFi
An Important Milestone For Steem: Robiniaswap Launch
Thank you for reading.
Image Sources: https://undraw.co/ and https://giphy.com/
Hi @muratkbesiroglu
Thanks for bringing up this important topic.
Understanding what liquidity pools are, how do they work and why do we need them in the first place is a must for anyone who want to be involved in DeFi. Wouldn't you agree?
(actually, I'm not even sure if platforms like pancakeswap, uniswap or robiniaswap should be considered DeFi. Simply because those seem to be centralized projects. I wonder why don't we call it CeFi instead? Any idea?)
Back to main topic:
I find it quite difficult to understand. So we do not need to "match" price placed by sellers and buyers. So what determine price of the token?
Solid read. Upovted already :)
ps.
could you perhaps check out my latest post (MINING RobiniaSwap (RBS) Tokens? Could you be making one of these mistakes?) and help me bring more traffic to it by resteeming this publication?
Cheers, Piotr
Hi Piotr,
Thank you for your comments.
Centralized exchanges work on centralized hosts. Decentralized exchanges like Uniswap and Pancakeswap are decentralized applications(dapps) working on Ethereum and Binance Smart Chain blockchains which are decentralized. The ideal dapps are managed by DAOs(decentralized autonomous organizations) consisting of token holders.
The price is determined by supply and demand. People buy from the pool and sell to the pool. The pool automatically adjusts the price considering supply and demand.
Best Regards,
hi @muratkbesiroglu
I've small question related to liquidity pools and impermanent loss.
I'm trying to wrap my head around it and based on my understanding:
in that case I would need 5000 RBS tokens and 1000 usd worth od BUSD. Is that correct?
Now, what would happen if price of RBS would:
a) scenario one: RBS would drop down to 0.1$ (50% drop)
b) scenario two: RBS would go up to 0.4% (100% increase)
I presume that the moment I exit liquidity pool, then I would end up still with 1000usd worth of BUSD, but amount of RBS tokens would be different.
Now, my question is: how many RBS tokens would I have at the end of the day (depending on the scenario).
Enjoy your weekend buddy,
Yours, Piotr
Hi Piotr,
That is correct.
You would have 1500 USD in total if you had the two cryptos separately. But you will have 707 dollars worth of BUSD(707 BUSD) and 707 dollars worth of RBS(7070 RBS) in the liquidity pool. (%5,72 extra loss because of impermanent loss)
You would have 3000 USD if you had the two cryptos in separate. But you will have 2828 USD worth of tokens in the liquidity pool. (3535,5 RBS and 1414,4 BUSD)
Best Regards,
thanks for that feedback @muratkbesiroglu