Dive Into DeFi

Dive Into DeFi: Liquidity Pools Explained

Take a Dive into DeFi with KCrypto, explaining all the basics revolving around liquidity pools

For traditional investors, a message: Forget everything you know about how markets work. This will make what I’m about to say much easier to digest.

What in The World is a Liquidity Pool?

Well, it’s exactly what it sounds like. A pool of liquidity. Before we go further, let’s set some ground rules:

  1. A liquidity pool is made up of two or more assets (Example: USDT and Ethereum. I will use this as my example throughout this series).
  2. Liquidity is provided by holders of the assets.
  3. An investor can sell one of the pool assets to the pool, in exchange for another asset within the same pool. Example: You sell Ethereum to the pool, and the pool sends you USDT.
  4. Investors pay a fee to the pool when exchanging an asset.
  5. Liquidity providers all share the fees paid by investors.

With these rules set, we can see that liquidity providers benefit from providing liquidity; they earn fees. Now you might wonder, how does the pool know how much Ethereum to give you if you sell USDT to it? This answer varies depending on where the pool is held, but it’s generally done by a scarcity/surplus formula. If I sell USDT in exchange for Ethereum to a pool, immediately following my transaction the pool has more USDT and less Ethereum. The next Ethereum purchased from the pool will be slightly more expensive. The same is true in reverse. If I sell Ethereum to the pool, there is now more Ethereum in the pool, making it slightly cheaper for the next buyer. Arbitrage traders can then spot opportunities for cheap or expensive Ethereum, and seek to capitalize on the opportunity. This ensures the price of Ethereum is consistent across pools and exchanges.

That Was Boring, I Know

But hear me out, that boring technical stuff is what makes this groundbreaking. We are all the market makers now. Investors no longer buy and sell from each other, but rather from the pool itself. This is known as automated market making. There is always a buyer, and always a seller, ready, on demand. I find that to be incredibly cool. Still bored? Let’s take this further.

New Income Potential

Say I hold Ethereum as a long term investment. It just hangs out, and my value is subject to volatile swings. I hope one day it’s worth more. It probably will be, but long term appreciating investments are not for every portfolio.

I can now pair my Ethereum with USDT in a pool, earning what I refer to as a dividend — the pool fees. This pair will also stabilize my Ethereum investment. Being paired with USDT means the Ethereum price movements will be half of what they would be on their own. If Ethereum doubles in value, half of that increase will be absorbed by the USDT side of the pool as they are always held in a 1:1 value ratio by arbitrage traders. This may not be ideal for the long term hold, but as they say, different strokes for different folks. This is what is known as impermanent loss, only becoming permanent when the investor withdraws their liquidity share from the pool. Also keep in mind, this is a loss on what could have been, not an actual loss of value.

Displays the amount of loss incurred vs the movement of an assets price

Now, Let’s Boost it

Many platforms add an incentive on top the pool fee itself. The incentive is often a governance token, and holds its own value. Receiving this token can significantly boost returns, making a 20% to 30% yield on an Etherum/USDT pair fairly easy to find in the marketplace. Simply sell off the “bonus” token, and bank some extra cash. Over time, the extra yield with some possible appreciation from the pooled tokens can provide an excellent investment vehicle for those looking for stabilized returns with the chance of crypto-unique capital gains.

If you think 30% sounds great, then you will lose it when you meet yield farming. At this moment I am providing BNB paired with DOT as liquidity. I like both projects, and am not too fearful of incurring long term capital losses. I am confident that both cryptos will go up in value over time. Either way, I’m here for the sick yield. The pool is currently paying me an APY of 100.8% thanks to the pool fees + platform incentive token. Bonus points if you can name the platform. (Hint: Think breakfast food).

Liquidity Pools on Leading AMM PancakeSwap

I think that’s good for now, we’ll dive further into food-based yield farms in the next chapter.

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