What is Liquidity Pool, and how does it work?

The term liquidity pool refers to collecting digital assets and engaging in a sharp agreement to provide equity to decentralized exchanges. Liquidity is an essential part of cryptocurrency and financial markets.

What is meant by Liquidity pool?

A liquidity pool is a digital asset of cryptocurrency locked in an intelligent agreement, resulting in the fastest equity transactions.

Automated Market Makers (AMM) are the major component of the liquidity pool. The protocols used by the liquidity pool to trade are automated rather than in a traditional market of buyers and sellers. Users of AMM provide a liquidity pool with tokens and their mathematical formula. Liquidity pools are helpful for online games and yield farming.

In liquidity pools, there are Liquidity Providers (LPs) in which the liquidity pools are designed to inspire the other crypto users. At a certain period, the LPs are rewarded with fees and motivates equal to the amount of equity they provide. They are called Liquidity Provider Tokens (LPTs). In decentralized finance, this Liquidity provider token can be used.

On the platform of Ethereum with ERC-20 tokens, the common decentralized finance uses are SushiSwap (SUSHI) and Uniswap.

The main motive of Liquidity Pool

In trading, the most common are done by the investors/traders to analyze the expected price and implement price, which is done in both traditional and crypto markets. The main aims of liquidity pools are to inspire the users and give liquidity for shares. At the same time, trading with a liquidity pool like Uniswap doesn’t require an expected price and implement price. AMM eliminates the gap between the buyers and sellers of tokens, making trade easy on a decentralized exchange market and regular. 

Work of liquidity pool:

The following steps are to use the liquidity pool. Here is one example, by using Sushiswap, a trader investing $20,000 in BTC-USDT.

1. Go to Sushiswap
2. Find BTC-USDT liquidity pool.
3. Then deposit 50/50 by splitting the BTC and USDT, i.e. deposit $10,000 value for BTC and deposit $10,000 worth for USDT.
4. Then receive the BTC-ISDT liquidity provider tokens.
5. After that, deposit liquidity provider tokens to the BTC-USDT pool.
6. Then the locked period that is agreed you hold within a vault and get the SUSHI token as a reward. It will be fixed in one week or three months.

Some popular providers of liquidity pools

Many decentralized systems purchase AMM to use liquidity pools to trade in an automated way. There are popular platforms:

Uniswap

This platform is an open-source service exchange in which anyone can start the exchange pair for free. These platforms allow users to trade Ethereum with ERC-20 tokens without centralized service.

Curve

Based on the Ethereum network are stable coins for a decentralized liquidity pool. The stablecoins are not eruptive, so they provide a reduced deficit.

Balancer

A decentralized platform benefits the liquidity providers with a few pooling options like private and shared liquidity pools.

Advantages and Disadvantages of Liquidity Pools

Advantages

• Performing transactions at real-time market prices clarifies decentralized exchange trading.
• It allows users to provide equity and get rewards, interest, and the annual yield on the crypto tokens.
• To examine the information transparent, they kept security contracts used publicly visible.

Disadvantages

• There are small groups to handle the liquidity pool funds, which are totally against of decentralized system.
• There are poor protocols which will risk hacking the security and also causes loss for equity providers.
• There will be a risk for frauds like rug pull and scam
• The temporary loss can be exposed.

How do they earn money?

While adding tokens into the pool in exchange, the LPs receive interest in the form of fees from trading people. This process is also known as liquidity mining. On the Uniswap platform, there is a fixed transaction fee of 0.3%; while trading in liquidity, the LPs can earn anywhere between 2% and 50% annually. Some LPs come between the numerous liquidity pools to make more money. This process is known as Yield farming, in which the yield is interest from staking crypto assets that can earn the traders.

Some challenges:

1. Firstly the temporary loss of LP tokens. This happens because of several factors, such as price explosive or hacking.
2. Issues with the innovative agreement, because if theft occurs, no legal assert is given that it is a decentralized system. 
3. Having poor protocols can have the risk of hacking the system and loss for traders or investors.
4. It becomes an unsafe attack if fraud or faulty developers create an agreement and don’t lock the liquidity pool.

Conclusion

A liquidity pool is the most straightforward concept to understand. The collection of funds is locked in an intelligent agreement that provides equity to decentralized exchanges. This is sage to save your money but has some poor protocols. Just take care while investing in it. Traders or investors should be aware of the challenges also. May this above help you get detailed information on the Liquidity pool, Liquidity pool providers, and Liquidity provider tokens.