How Do Liquidity Pools Work?
Hey everyone, I'm Lachlan from Multichain Media and I’ll be explaining a core concept of DeFi: liquidity pools!
In traditional financial markets, market makers play a crucial role in ensuring that there is enough liquidity for traders to buy and sell assets. Market makers are entities that constantly buy and sell assets to provide liquidity to the market., making a profit through buy/sell spreads.
However, in the world of cryptocurrency, the absence of market makers and the low trading volumes on many decentralized exchanges (DEXs) mean that traders often have to deal with significant price slippage. Price slippage occurs when there is not enough liquidity in the market to fill a trader's order at their desired price, resulting in the order being executed at a worse price. This is where liquidity pools come in.
Those with idle assets can pool together pairs of assets to form liquidity pools, becoming liquidity providers (LPs) in turn. In the above graphic, we see LPs depositing ETH + USDC into an ETH/USDC liquidity pool. Each asset pair has its own liquidity pool, with varying amounts of liquidity within them. LP tokens are provided to these LPs, representing ownership over a percentage of the liquidity pool’s assets. As the liquidity pool grows in value, so too should the value of the LP tokens.
On the other hand, traders go to a DEX interface such as Uniswap or Curve in order to swap assets. Our example shows USDC being swapped in exchange for ETH, with a small trading fee (0.3% on Uniswap) being paid to LPs as compensation. In order to maintain a balance of assets within a liquidity pool, pricing changes algorithmically through what’s known as automated market makers (AMMs). Price changes incentivize arbitrageurs to trade the opposite way, bringing assets back to parity.
The beauty of this is that traders may trade cryptocurrencies in a decentralized manner while liquidity providers earn a passive income by contributing their funds to the pool. Liquidity pools are therefore an essential component of DEXs and are key to enabling cryptocurrency trading without intermediaries.