When liquidity is supplied to the pool, the liquidity provider (LP) receives special tokens called LP tokens
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Contrary to the actual pools that are filled with water, liquidity pools (LPs) are pools that are filled with crypto assets. They are actually smart contracts that allow traders to exchange tokens and coins, even if there are no buyers and sellers. Before we proceed, we would suggest you read our article on smart contracts here, as it is the technology that allows the liquidity pools to exist.
In the traditional stock market, matching engines follow the order book mechanism with which they buy or sell the required quantity of shares of an entity. When the price of a buy order and sell order is the same, a trade is transacted, i.e., the buyer gets the stock and the seller gets the cash. This can prove to be cumbersome and less efficient, as a buyer needs to wait for a seller who is ready to transact at the buyer’s quoted price.
Liquidity pools come into play to tackle this hassle. They use an algorithm that enables people to buy or sell an asset irrespective of the price differences between both parties and can be processed at any time of the day. Liquidity pools usually contain pools of different assets such as Ethereum and stablecoins such as USDC, USDT, etc. Liquidity pools are basically codes that are a smart contract, written to hold certain funds, do mathematical functions with that funds that allows trades to happen in real time.
Most of the liquidity pools contain a mix of two assets such as Ethereum and DAI or any other set of coins as pairs in a 50:50 ratio. Balancer is one of the protocols that runs with a complex algorithm which can support up to eight coins in a liquidity pool in different proportions. The fundamental behind this is that they use a mechanism called “Constant Product Automated Market Maker”.
Can we invest in LPs?
As an investor, one might wonder why to invest in liquidity pools over other investment platforms. Investors who put their money in liquidity pools are called liquidity providers and they are paid from the fees that are collected from all the trades that take place in each pool. A liquidity provider provides two coins or tokens to a liquidity pool. This enables traders to trade back and forth using the funds available in the liquidity pool and these traders pay a fee. All the investors of the pool split up the fees proportionately depending upon their share of funds. When liquidity is supplied to the pool, the liquidity provider (LP) receives special tokens called LP tokens in proportion to how much liquidity they supplied to the pool.
Few examples of LPs
One of the first projects that used a liquidity pool was Bancor. However, these pools have become widely popular by Uniswap and Curve. Curve Pools (the liquidity pools of curve), by implementing a slightly different algorithm are able to offer lower fees and lower slippage when exchanging the tokens. On the other hand, Balancer allows up to eight tokens in a single pool. There are also a number of other defi applications like Sushiswap, Kyber Network, AAVE and more that offer higher than average liquidity returns.
Liquidity pools are an alternative method to earn passively using crypto tokens. The first step is to choose a solid platform and the best pools to ensure a steady and safe income. As liquidity is the most prominent factor for any of the defi projects, liquidity pools operate in a tough competitive environment, as investors keep looking for protocols and projects that are providing higher liquidity. These pools have experienced explosive growth in a short span and are expected to revolutionize the decentralized finance landscape.
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Disclaimer: This article was authored by Giottus Crypto Exchange as a part of a paid partnership with The News Minute. Crypto-asset or cryptocurrency investments are subject to market risks such as volatility and have no guaranteed returns. Please do your own research before investing and seek independent legal/financial advice if you are unsure about the investments.
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