What is a Liquidity Pool And Liquidity Provider

What is a Liquidity Pool and Liquidity Provider_
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Learn to understand the building blocks of the DeFi revolution

Liquidity pools and liquidity providers are everywhere when you’re swapping tokens on a decentralized exchange. But to safely navigate in crypto, you need to understand how this works. Join us while we break everything down and get to know what liquidity pools are, how they work, the risks of low liquidity, being a liquidity provider, and more. Let’s go!


What is liquidity in DeFi?

Liquidity, in the realm of finance and investments, refers to the ease with which an asset or security can be quickly bought or sold in the market without causing a drastic change in its price. Think of it as the “fluidity” of an asset’s conversion into cash.

Highly liquid assets, like most major currency pairs or popular stocks, can be sold readily with minimal price fluctuation. Conversely, less liquid assets, such as real estate or rare collectibles, might require more time to sell and can often involve price concessions to accelerate the sale.

In the decentralized finance (DeFi) ecosystem, liquidity is vital as it ensures smooth transactions, fair asset pricing, and reduced slippage when trading or swapping tokens.

What is a liquidity pool?

A liquidity pool is a smart contract with locked tokens that are used to enable decentralized trading. The pool acts as a kind of “storage” in which market participants put crypto assets together to provide the necessary liquidity for everyone who wants to exchange this asset.

The emergence of liquidity pools was a kind of ‘response’ to the inefficiency of the order book system within decentralized exchanges. Using order books, market makers faced a significant problem in the form of high gas fees. As a result, executing trades turned out to be very expensive and not profitable for both market makers and traders.

Another driver for launching liquidity pools was low network throughput. When it comes to billions of dollars in daily trading, blockchains cannot provide fast enough transaction speeds.

How does a liquidity pool work?

The simple liquidity pool includes a trading pair of 2 tokens equivalented in value to each other. For example, let’s take Ethereum (ETH) and the US dollar coin (USDC) pair. 

The liquidity provider must add such an amount of ETH and USDC to the pool comparable in value. If the provider decided to invest 1,000 ETH in the pool, he must accordingly invest 2,000,000 USDC. In this case, 1 ETH is equal to 2,000 USDC (we use hypothetical asset value).

Anyone can use this pool to exchange USDC for ETH (and vice versa). For example, if a user decided to buy 100 ETH, he must send 200,000 USDC from his wallet to this liquidity pool. In return, the user receives 100 ETH.

What is a liquidity provider?

A liquidity provider is a user who provides tokens belonging to the liquidity pool. The largest providers are mostly the creators, but this isn’t always the case. In the future, the pool may be joined by users who can make a deposit. By essence, liquidity pools are made through community efforts. A liquidity provider always provides currencies to two sides of the pool, so in the case of the ETH-RADAR pool, liquidity providers provide both ETH and RADAR.

The provider of the liquidity pool receives a percentage from the trading fees that users pay when they make a trade. For example, the crypto exchange has set fees of 0.3% for pairs. The amount is charged to the user for the transaction and is distributed among all providers by their share.

For example, if a liquidity provider contributed 10% of the total pool share, then for every $100 of commission, they will receive $10 of profit.

Liquidity score and the dangers of low liquidity

The sting of impermanent loss, where liquidity providers potentially face a drop in the value of their pooled assets against holding them, is sharp in DeFi landscapes with limited liquidity. Delve into a concise breakdown of the imperative of consistent liquidity:

  • Volatility: Thin liquidity means minor trades can have outsized effects, making asset prices unpredictable.
  • Trading Discrepancies: The frustration of expecting a trade price and seeing it change due to liquidity constraints is known as ‘slippage’.
  • Manipulative Tactics: Sparse liquidity makes dapps more susceptible to price manipulation, and when a token’s ownership is too centralized, ‘rug-pulls’ become a potential menace.
  • Market Movement Challenges: Indeterminate prices in low liquidity settings can obstruct optimal market entry or exit, sometimes trapping investors.

Recognizing these pitfalls, DappRadar offers the Liquidity Score tool, providing clarity on a dapp’s liquidity landscape, and empowering users to make safer DeFi decisions. Keep in mind that a low Liquidity Score isn’t always a bad thing, but should be something to take into consideration when buying into a project. 

Liquidity Score DappRadar Feature

Navigate DeFi dapps with insight. DappRadar now displays an alert when a certain cryptocurrency has a low Liquidity Score. You can find these alerts for example on product pages, as displayed in the mock-up above. We advise every community member to do good research before investing into cryptocurrencies, and never invest more than you can afford to lose.

Thanks to the launch of liquidity pools, many crypto platforms have been able to make themselves known in the crypto market. We’ve all witnessed this boom in 2020 and a return in popularity in 2023. A prime example is the Uniswap decentralized crypto exchange. To date, the amount of locked funds (TVL) on Uniswap V3 exceeds $3 billion.

The largest crypto exchanges that use Ethereum-based liquidity pools include Uniswap, Sushiswap V3, and Curve. Decentralized exchanges such as PancakeSwap also successfully operate based on the BNB Chain, while Polygon’s QuickSwap comes to mind.

Want a deeper dive into the DeFi landscape? Explore the DappRadar DeFi dapps Ranking to stay ahead of the curve.

DappRadar DeFi TVL Ranking

Did you know DappRadar also taps into liquidity pools? Using the DappRadar Token Rankings users get the best rates on the market, as we search automatically for the most optimal trades. Exchange your tokens now on DappRadar’s Token Swap.

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