What is a liquidity pool?

Liquidity providers (LPs) supply liquidity pools with funds. A liquidity pool can be thought of as a large sum of money that traders can trade with. LPs earn fees from trades that take place in their pool in exchange for providing liquidity to the protocol. LPs deposit an equivalent value of two tokens – for example, 50% ETH and 50% DAI – to the ETH/DAI pool in the case of Uniswap.

Is it true that anyone may work as a market maker? Indeed! Adding funds to a liquidity pool is simple. The protocol establishes the incentives. Uniswap v2, for example, charges traders 0.3 percent, which goes directly to LPs. To entice more liquidity providers to their pool, other platforms or forks may demand lower fees.

Why is attracting liquidity important? Due to the way AMMs work, the more liquidity there is in the pool, the less slippage large orders may incur. That, in turn, may attract more volume to the platform, and so on.

 

The slippage issues will vary with different AMM designs, but it’s definitely something to keep in mind. Remember, pricing is determined by an algorithm. In a simplified way, it’s determined by how much the ratio between the tokens in the liquidity pool changes after a trade. If the ratio changes by a wide margin, there’s going to be a large amount of slippage.

 

To make this specific, let’s say you wanted to buy all the ETH in the ETH/DAI pool on Uniswap. You’d have to pay an exponentially higher and higher premium for each additional ETH, but still never could buy all of it from the pool. The reason is because of the formula x * y = k. If either x or y is zero, meaning there is zero ETH or DAI in the pool, the equation doesn’t make sense anymore.

 

Parallel to the AMMs and liquidity pools. You’ll need to keep in mind something else when providing liquidity to AMMs – impermanent loss.