Today’s spotlight is on how to use the liquidity pool on DEXs – the benefits and the risks involved.

A liquidity pool is a pool of cryptocurrency assets locked into a smart contract on a decentralized exchange (DEX). 

It is designed to enable traders to buy and sell assets without waiting for a buyer or seller to be found.

Let’s dive deep into this in the section below.

What is a Liquidity Pool? – How to Use Liquidity Pool on DEXs

As mentioned earlier, a Liquidity Pool is a pool of cryptocurrency assets locked into a smart contract on a decentralized exchange (DEX). 

It is a fundamental concept in decentralized finance (DeFi) and is commonly associated with automated market makers (AMMs) like Uniswap, SushiSwap, and PancakeSwap.

To explain how Liquidity Pools work on DEXs, I will be using the illustration below.

Imagine that there are two traders, Alice and Bob. 

Alice has 100 Ethereum (ETH) tokens, and Bob has 100 USDC stablecoins. 

Then, they decided to create a liquidity pool on Uniswap for the ETH-USDC trading pair. 

To do this, they each deposit 50 ETH and 50 USDC into a smart contract, with a starting price of 1 USDC equals 1 ETH.

Now, the liquidity pool contains 50 ETH and 50 USDC. 

Let’s say another trader named Mike comes to Uniswap looking to swap his 10 ETH for USDC. 

When he makes this trade, the smart contract takes his deposit of 10 ETH from the pool and gives him the equivalent USDC based on the current pool price. 

As a result, the pool balance will change to 60 ETH and 40 USDC.

It then means that 1 ETH cannot equal 1 USDC anymore. 

The smart contract may adjust the pricing to 2 USDC for 1 ETH to regain the balance since there’s more ETH in the pool. 

This price adjustment is known as “slippage.”

And that is how trades are completed seamlessly on DEXs with the aid of liquidity pools.

This is better than the Order Books used on CEXs, where traders must wait to be merged with other buyers or sellers before their trades can be completed.

The liquidity pools on DEXs make trading multiple coins with many pairs easy.

These pools typically comprise two assets – ETH/USDC, BTC/USDT, SHIB/USDC, or UNI/USDT.

Therefore, traders can execute trades with the pairs provided.

For example, an ETH/USDT pool shows that traders can trade their USDT for ETH or ETH for USDT.

Let’s look at the benefits of liquidity pools.

Benefits of Liquidity Pools

In addition to making trading more efficient, here are other benefits of liquidity pools:

1. Decentralization

Liquidity pools are often hosted on decentralized platforms, thus reducing the risk of censorship or third-party control.

This way, anyone can create a pool and become a liquidity provider.

2. Passive Income

Liquidity providers (LPs) can earn fees by depositing their assets into a liquidity pool.

When traders make swaps, they pay a fee that is proportionally distributed among the LPs based on their share of the pool.

This can provide a source of passive income for them.

3. Price Stability

The liquidity pool also ensures a crypto asset’s price stability by balancing the tokens’ supply and demand.

But that does not mean that liquidity pools are without risks.

4. Accessibility

Liquidity pools are open to anyone with an internet connection and suitable assets. There are no intermediaries, which means users have direct access to DeFi markets.

5. No KYC

Liquidity pools typically do not require Know Your Customer (KYC) verification, allowing users to maintain a degree of privacy.

I listed some of the risks below.

Risks Associated With Liquidity Pools

Some risks to note are:

1. Impermanent Loss:

Liquidity providers are exposed to impermanent loss, a concept specific to AMMs.

This occurs when the price of assets in the pool diverges from the initial ratio at which they were deposited.

LPs may end up with fewer assets than they initially put in, particularly if there are large price swings.

2. Smart Contract Risks:

Liquidity pools operate on smart contracts, with vulnerabilities that malicious actors could exploit.

This risk includes smart contract bugs, hacks, or vulnerabilities in the underlying blockchain.

3. Price Manipulation:

In smaller pools or low-liquidity assets, there is a risk of price manipulation, where a single large trade can significantly impact the asset’s price.

4. Imbalance in Pools:

Some pools may become imbalanced, with one asset having significantly more liquidity than the other.

This can lead to skewed prices and potential arbitrage opportunities.

5. Impermanent Loss Mitigation:

LPs need to manage their positions to mitigate impermanent loss actively.

Strategies like impermanent loss protection tokens (ILPs) can help, but they also have their own risks.

6. Market Risk:

Liquidity providers are exposed to the overall market risk of the assets they deposit into the pool.

If the value of these assets drops significantly, LPs can experience losses.

7. Regulatory Uncertainty:

The regulatory environment for DeFi and liquidity pools is evolving and can vary by jurisdiction.

Users should be aware of potential legal and tax implications.

8. Time Consuming

Liquidity providers are responsible for managing their pool. This can be a complex and time-consuming process.

Conclusion

To sum it up, liquidity pools are powerful tools that can be used to trade cryptocurrencies and earn passive income.

However, it is essential to understand the benefits and the risks involved before using them.

Users should carefully assess these risks and consider their tolerance before participating in liquidity pools.

Proper diversification and risk management strategies are essential for mitigating potential losses.

I hope this post has helped you understand how liquidity pools work on DEXs.

If you want to learn how to trade cryptocurrencies profitably, sign up on Afibie and create an account on Bybit.

You can also join our Telegram group, where we share trading signals daily and host DeFi classes as well.

I’ll see you in the group and my next post.