Written by: Christopher Shen

What is a liquidity pool?

A liquidity pool is a collection of two types of cryptocurrency tokens that are locked into a smart contract. The pool attempts to maintain a 50:50 balance of value for each token, allowing individuals to exchange one currency for another within the pool. An automated market maker program is included in the smart contract, which adjusts the conversion rate between the two tokens within the liquidity pool based on their respective scarcity. This makes it such the pool is able to stay at it’s 50:50 balance of value. The tokens within the pool are provided by liquidity providers who stake an equal value of both coins. In return for staking their tokens, liquidity providers receive a fee for every exchange made in the pool. As more individuals use the liquidity pool to exchange tokens, the fees collected by liquidity providers increase.

If the market value of a specific token differs from the conversion rate of another token, considering the market value of the latter token, arbitrage traders can step in and buy or sell the token until its price is corrected. Arbitrage trading takes advantage of market inefficiencies to profit from the difference in price between different exchanges or trading pairs. When a token is priced unfairly in a liquidity pool, arbitrage traders can buy the token on a cheaper exchange and sell it on the liquidity pool, or vice versa, until the price of the token in the pool is brought back to its fair market value by the automated market maker. This process of arbitrage trading helps to keep the prices of the tokens in the pool aligned with their fair market value and ensures that the liquidity pool operates in a fair and efficient manner.

Benefits of using a liquidity pool

The main benefit for a trader to use a liquidity pool is that it is faster than a peer-to-peer exchange. The token is readily available and that results in less delay when transactions take place in a pool. Additionally, automated market makers make the values of the two cryptocurrencies fairly priced and not as susceptible to market manipulation, as the price is determined by the supply and demand of the tokens within the pool.

Looking closer at Automated Market Makers

Automated market makers use various methods to determine the value of a token relative to another token. One popular method is the x*y=k formula. Here, x represents the amount of one token in the liquidity pool, while y represents the amount of the other token. The constant k is the product of the two amounts. When a trader wants to buy or sell one token for another, the AMM adjusts the prices in the pool to maintain the x*y=k formula. If there is a higher demand for one token, its value will increase and the AMM will require the trader to provide more of the other token to maintain the balance. Conversely, if there is a higher supply of a token, its value will decrease and the AMM will require less of the other token for a trade. This mechanism ensures that liquidity pools don’t run out of liquidity and encourages balance. If the imbalance between tokens becomes too high, trades will become less valuable, making it less attractive for traders to trade in the same direction.

The liquidity provider perspective and impermanent loss

As a liquidity provider, one of the primary incentives to provide liquidity is to earn fees from transactions that take place in the pool. These providers can make quite a bit of profit if the tokens are traded frequently. However, there is a potential risk called impermanent loss that liquidity providers need to consider before staking their coins out. Impermanent loss occurs when the value of one token in the pool changes significantly compared to the other token, resulting in a reduction in the value of the liquidity provider’s holdings compared to simply holding the tokens themselves. For instance, imagine a liquidity pool with token A and token B. If token A becomes more valuable over time while token B remains the same, more users will want to trade token B for token A. As a result, the liquidity provider will end up with more token B and less token A in their holdings. However, in this scenario, the liquidity provider would have been better off simply holding the original amount of token A and token B. This difference in potential profit made is the impermanent loss of providing liquidity to the pool. In this scenario, impermanent loss can lead to a reduction in the overall value of the liquidity provider’s holdings, resulting in a potential loss compared to simply holding onto the tokens.

Ways to reduce impermanent loss

An effective way to reduce the risk of impermanent loss is to provide liquidity for stablecoins. Stablecoins are less volatile and tend to have a relatively stable price, making it unlikely for their price to significantly change relative to each other. This results in a lower risk of impermanent loss compared to liquidity pools that trade volatile assets. In the real world, we observe that liquidity pools that trade stablecoins have a large number of participants who stake their assets due to the lower risk.

To further enhance this strategy, one can use weighted pools where the value ratio of the two assets is set to a different ratio compared to the standard 50:50 ratio. By adjusting the ratio based on the volatility of the tokens in the pool, it is possible to reduce the pool’s sensitivity to price fluctuations, which in turn reduces the risk of impermanent loss. For example, if a pool has a majority of stable assets such as USDC and a small amount of volatile assets like ETH, then the ratio can be set to something like 90:10 or 95:5. This approach can be particularly useful for liquidity providers who want to reduce their exposure to price risks while still earning fees for providing liquidity to the pool. The higher the ratio the more similar the pool would be to just holding one asset, with the added benefit of earning fees for providing liquidity to the pool.

Ultimately, as the world of decentralized finance continues to evolve and new technologies are developed, we can expect to see even more innovative solutions to minimize impermanent loss and increase the efficiency and pricing of liquidity pools. The possibilities are truly endless, and it will be exciting to see what the future holds for liquidity pools in the decentralized finance space.

Abrol, Ayushi. “A Complete Guide on Impermanent Loss.” Blockchain Council, 22 Feb. 2022, www.blockchain-council.org/defi/impermanent-loss/.

Cryptopedia Staff. “Decentralized Finance and Impermanent Loss.” Gemini, 17 May 2021, www.gemini.com/cryptopedia/decentralized-finance-impermanent-loss-defi#:~:text=*%20y%20%3D%20k.-,x%20*%20y%20%3D%20k,of%20the%20automated%20pricing%20mechanism.

Lapuschin, Matias. Sensorium, What are liquidity pools? DEFI liquidity explained, 13 Jan. 2023, sensoriumxr.com/articles/what-are-liquidity-pools.