Definition of ‘Liquidity Pool’ - A liquidity pool can be thought of as a pot of cryptocurrency assets locked within a smart contract, which can be used for exchanges, loans and other applications.
What Is a Liquidity Pool?
Liquidity pool definition — A liquidity pool is a platform where a pool of cryptocurrencies or tokens are crowdsourced and locked in a smart contract. And while being locked, they are being used as sources for loans for exchanges, and other applications.
Think of it as the traditional finance system that loans money with the difference being that in CeFis, liquidity is provided by a central source such as a stock exchange or bank.
The smart contracts here are used to guide the trading of these digital assets on a decentralized exchange (DEX).
How do liquidity pools work?
The liquidity pool is operated based on the automated market makers (AMM); hence, investors and borrowers do not need a pairing mechanism to pair individuals whose needs and available investments match. Instead, needs are matched directly with the contract. This means that with the liquidity pool, no direct counterparty is needed for trade to get executed.
Sometimes, certain offers may stay on traditional exchanges for a long time without finding a match. So, instead of a peer-to-peer, we have the peer-to-contract system on the liquidity pool. So, by design, the liquidity pool eliminates the need for an order book.
While the recipient of the token sees the contract as the provider of the fund, the actual provider is at the backend. He provides liquidity and receives steady proceedings from his investment.
How are investors compensated?
Different liquidity pools have different methods and rates of compensation. But one common way is through the transaction fee that is charged for every swap. The accumulation of this charged fee is then distributed proportionally to each investor in the liquidity pool. Investors can earn up to 50% annual interest as liquidity provider fees while some earn as low as 2%. Earnings are dependent on the wide use of the liquidity pool.
Are Smart Contracts Safe?
Past occurrences have shown that smart contracts are not the best definition of 'safe.' There have been several instances of hacked smart contracts. However, this does not rule out the fact that there are few safe smart contracts in the market. Although few, they exist.
So, the question now is how can we identify the secure ones? There are different pointers that mark out a safe smart contract. But we will advise that you consider the value of the funds that are already locked in the contract.
The more the funds and value of assets, the higher the security of the pool. For instance, a smart contract with about $1 million can be considered secure.
Can you lose money in a liquidity pool?
Unfortunately, this question tilts towards the positive. So, yes! There is the possibility of losing your money in a liquidity pool. It is just like every other Investment type. Investments come with their risk, whether low or high.
However, the loss is minimal and impermanent when funds are provided on a decentralized exchange.
Losses are mostly recorded when a token decreases in value. And in situations like this an investor is forced to sell the higher valued token for the crypto that is falling in value. However, as mentioned earlier, the token has the prospect to appreciate in value over a while, which helps you bounce back. Hence, loss is impermanent.