How do Liquidity Pools Work?

If you have been around in the crypto space for some time, you would know about CEXs and DEXs. CEXs are centralized exchanges where funds and assets are kept and regulated by the exchange platform. DEXs are independent platforms designed to allow crypto buyers to have complete authority over their funds and trade without giving up control to any custodian. One of the major advantages of CEXs over DEXs is their liquidity. Centralized exchanges pull funds from thousands (if not millions of investors) and store them in cold wallets and other mediums. The funds in DEXs are held by the owners and this can make it difficult to track and ascertain the liquidity volume of any particular token. Today DEXs and Defi platforms can comfortably compete with the kind of volume seen on centralized exchanges. One major factor responsible for this development is the liquidity pool. Today, we want to take a look at liquidity pools. 

What is a liquidity pool?

A liquidity pool is a mechanism by which decentralized exchanges can facilitate trading, lending, and other money functions. Simply put, a liquidity pool is a collection of funds provided by users of a DEX, and locked in a smart contract. When users provide funds in a liquidity pool, they are rewarded with a proportion of trading fees equivalent to what they have provided in the pool. Anyone with a big bank can be a liquidity provider. 

How do liquidity pools work?

If you want to understand how liquidity pools work in decentralized exchanges, you need to understand how order books work in centralized exchanges. An order book is a set of open orders in a given market. The CEXs operate by matching a buy order with a corresponding sell order and then closing the trade. Essentially, you can think of it as a peer-to-peer transaction. In DEXs, there are no order books to match transactions because third parties are not supervising the trade. Your trade is executed directly with the liquidity pool and no other traders. This means that you can quickly buy or sell an asset regardless of its trading volume or current orders. You can think of this as a peer-to-contract transaction and AMMs are the drivers of these transactions.

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How risky are liquidity pools?

Impermanent loss

When you invest in a liquidity token and the price goes down against the dollar, you will have an impermanent loss. They are called impermanent losses because the price could rebound at any time. If you are investing in a two-sided liquidity pool, you should do proper research and invest only what you are ready to lose. 

Smart contracts risk

Liquidity pools are secured by smart contracts either built on Ethereum, Solana, or other chains. Even though smart contracts are secure and reliable, there are risks involved when it comes to liquidity pools. When you invest your funds in a liquidity pool, and the smart contract is flashed or has a bug, you could lose your funds permanently.  

Rug Pull

The rug pull is one of the most popular scams in the crypto ecosystem. That is why it is necessary to research the developers behind a liquidity pool before you invest your funds. If you invest in liquidity where a fraudulent developer has an admin key to the smart contract, your funds could be lost permanently. 

Summary

Liquidity pools are important for the survival and working system of any decentralized exchange. It can be rewarding to invest in any liquidity pool. However, it can also result in huge losses. You should take the necessary steps to research the project and people behind any liquidity pool before you invest your funds there. 

 

Janet Brown