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What does a cryptocurrency liquidity pool mean? How does it work? What are the benefits of providing liquidity? We will answer these questions and help you understand the intricacies of the cryptocurrency market.
What is a cryptocurrency liquidity pool?
In simple words, cryptocurrency liquidity pools are vaults that contain the assets of traders and investors, providing a supply of liquidity to specific assets that users exchange on the exchange. If we consider traditional financial markets, the role of such pools is played by large banks, where the money of thousands of depositors is stored. Banks manage money; use it for lending and for other purposes. A liquidity pool is tokens frozen in smart contract accounts in cryptocurrency. Locked tokens ensure high trading activity on the trading platform. Smart contracts are self-executing; no intermediaries are needed for this. The performance of the pool is supported by automated market makers created on the basis of mathematical formulas.
The standard cryptocurrency liquidity pool is two tokens. Freezing two tokens creates a new market for their exchange within the pool. The first investor who sent his tokens must set the starting rate for their exchange when creating a pool. Each successive liquidity provider must lock an equal number of tokens for the pool. The threatens liquidity providers with a loss of capital if the established rate for the exchange of cryptocurrency and the current one differ significantly, so an opportunity for arbitrage is created.
Suppliers who have sent their tokens to the pool receive the so-called LP tokens; their number is proportional to the share of liquidity provided by the supplier. The platform takes a commission, which is divided among all participants in the pool when conducting a transaction involving a pool. If the supplier wants to return his locked tokens, he must burn the LP tokens.
Benefits of providing liquidity
The main advantage of the cryptocurrency liquidity pool is the ability to make an exchange, rather than a standard two-way deal. The trader does not need to look for another trader who will assign the same value to the asset as he does.
The smart contract is executed automatically, the exchange is made quickly, and the user of the exchange does not have to look for suitable deals or negotiate a price with other participants.
Another advantage is the low impact of the pool on the market. Transactions are simple, without creating a high load. The pool is already locked in a smart contract, and the price of tokens is controlled by a special algorithm. In addition, liquidity providers are rewarded for blocking crypto in the pool, because they refuse the opportunity to sell digital currency.
Who uses the cryptocurrency liquidity pool?
Traders and investors make a profit by becoming a liquidity provider. Becoming liquidity providers for exchange users is stimulated by rewards in the form of LP tokens. Liquidity pools are used by centralized and decentralized trading platforms, lending platforms, for example, Uniswap is an exchange for exchanging cryptocurrencies created on the Ethereum blockchain. There are cryptocurrency liquidity pools on Binance and other popular trading platforms.
What are the risks of pools?
Cryptocurrency liquidity pool is what ensures high trading activity. But there are risks, a trader should be aware of them. Pools experience intermittent losses periodically.
This is an uneven ratio of tokens in a pair, caused by a significant change in the course. Intermittent losses can lead to the loss of funds invested by suppliers. The most prone to intermittent losses are pools consisting of cryptocurrencies with high volatility. Also problematic are pools consisting of tokens, the prices of which differ significantly from each other.
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