What is a Liquidity Pool?

And why it matters.

7 min readAug 8, 2023

A Placecard NFT to show proof of a wallet's deposit into an LP.

The exact details of the Crypto or NFT project and its tokenomics could heavily influence the outcome of providing liquity. Always manage your risk accordingly. Not responsible for impermanent loss — Read more about impermanent loss below.

What is a Liquidity Pool?

A liquidity pool is a smart contract that contains a reserve of two or more cryptocurrency tokens in a decentralized exchange (DEX). It is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that facilitates trades between the assets on a DEX.

Instead of traditional markets of buyers and sellers, DEXs use automated market makers (AMMs) to facilitate trades automatically via liquidity pools. AMMs are a protocol that uses liquidity pools to allow digital assets to be traded in an automated and permissionless manner. Liquidity pools help to maintain liquidity on a network by rewarding users who contribute assets to the pool with a percentage of trading fees — proportionate to their contribution

Examples of Liquidity pools on Ethereum and Solana would be Uniswap, Sushiswap, 1 Inch, Orca, Raydium, and Pancakeswap for Binance Chain.

How do liquidity pools work?

Liquidity pools use automated market makers (AMM) to connect users trading pairs with the appropriate smart contracts for them. AMMs are the protocols used to aggregate and determine the market price of digital assets. Generally, AMMs provide the most reasonably accurate market price on liquidity pools for cryptocurrencies, and now NFTs on platforms like Tensor and Hadeswap.

Read Raydium’s docs on standard LPs here.

Benefits of Providing Assets to a Liquidity Pool

If the benefits fall in line with your risk management, there are several medium to high-risk approaches assuming the project has established success.

Decentralized Exchanges (DeX) rely greatly on liquidity due to high transaction rates; for this reason, decentralized exchanges need to be connected to liquidity pools that can help maintain a steady functional network that doesn’t delay transactions made by traders.

Benefits can be:

Earn a percentage of trading fees: Liquidity providers (LPs) usually earn a portion of the trading fees based on their share of the pool. This can provide an ongoing income stream.
Potential for Yield Farming: Many DeFi projects offer additional incentives such as governance or utility tokens for liquidity providers. This can enhance the returns for LPs.
Increasing Market Efficiency: By providing liquidity, LPs contribute to reducing price slippage and enhancing market efficiency, benefiting the entire ecosystem.
Potential for Arbitrage: Experienced traders may profit from arbitrage opportunities between different exchanges or pools.
Participation in Governance: In some protocols, LPs may receive governance tokens that allow them to participate in decision-making processes.

How do concentrated LPs differ from traditional LPs?

Concentrated liquidity pools allow liquidity providers to deposit funds within a specific price range, rather than across the entire price spectrum. Before CLPs enhanced the decentralized trading market, there were numerous health incentives to “double-dip” which essentially meant providing additional liquidity for the actual LP token at a higher market trade rate.

Unfortunately, the process is still inefficient at a protocol level, requires more on-chain signs, and has a higher result in impermanent loss due to less direct liquidity for LP tokens, therefore CLP has become a favorite in token aggregate pools due to better capital efficiency and scalability of TXNs.

How does CLP benefit compared to traditional LP?

Concentrated liquidity pools allow liquidity providers to deposit funds within a specific price range rather than across the entire price spectrum. This can provide a number of benefits:

Capital Efficiency: By concentrating liquidity within a specific price range, liquidity providers can offer more liquidity with less capital.
Improved Slippage: The higher the liquidity in the relevant price range, the less slippage a trade will experience, potentially offering a better trading experience.
Potential for Higher Returns: Liquidity providers may earn more fees as they are providing liquidity in the most traded price ranges.

Risks and Considerations for Hedging

When providing liquidity, one must be aware of risks such as impermanent loss. This occurs when the price of one asset in a pair changes compared to when you deposited them. This can result in owning less of one asset than if you had just held them.

To hedge this risk:

Choose Pairs Wisely: Select pairs where you expect relative price stability between the assets or are indifferent to changes in their relative values.
Utilize Derivatives or Other Hedging Instruments: Sophisticated LPs may use derivatives or other financial instruments to hedge against price changes in one or both of the assets in the pool.
Monitor and Adjust: Keep a close eye on the pool and make adjustments as needed based on changes in asset values or other market dynamics.

Healthy ROI Percentages

The concept of a “healthy” ROI depends on the individual’s risk tolerance, the specific assets involved, market conditions, and the particular liquidity pool.

Assess Risks: Understand all risks, including impermanent loss, smart contract risks, etc. Compare potential returns against these risks.
Consider Opportunity Costs: Assess the potential ROI in the context of other available investment opportunities.
Consult Historical Data: Look at historical returns for similar pools or assets to gauge what might be reasonable.
Stay Informed: Market dynamics change rapidly in the crypto / NFT space, and what may have been a good ROI yesterday might not be the same tomorrow. Stay informed about market and protocol developments.

My Orca CLP from the $BONK / $SOL pool.

Calculating Liquidity Needs

The ideal amount of liquidity needed to balance out volatility depends on several factors, such as trading volumes, token emissions rate, and market participants’ behavior.

Minimum Threshold: The minimum threshold would need to be enough to handle expected trading volumes without causing significant slippage. A common guideline might be to have enough liquidity to handle daily trading volumes.
The “Halving” of Token Emissions: If the emissions of $BOO tokens are halving in less than a week, this could lead to changes in supply and demand dynamics. The decrease in new supply might lead to increased scarcity and potential price appreciation. This should be considered when determining the liquidity needed within the specific price range.
Understand Trading Behavior: Analyzing historical trading data to understand where most trading occurs will help in concentrating liquidity where it’s most needed.

In the fast-moving world of DeFi, what constitutes a healthy ROI can vary widely and can change rapidly. Due diligence, a clear understanding of the risks and rewards, and possibly consultation with a financial professional can help in making sound investment decisions in liquidity pools or any other investment opportunities.

Liquidity Pools in DeFi (Automated Market Makers)

In decentralized exchanges (DEXs), liquidity pools are managed through smart contracts. These are self-executing contracts with the terms of the agreement directly written into code.

Automated Market Makers (AMMs): AMMs like Uniswap rely on liquidity pools rather than traditional order books. Liquidity providers deposit pairs of tokens in a smart contract, creating a pool that users can trade against.
Price Algorithm: The price of assets in the pool is determined algorithmically based on the ratio of the assets. This is often modeled using a constant product formula, like x ⋅ y = k, where x and y are the quantities of the two assets, and k is a constant.
Slippage and Fees: The larger the trade relative to the pool’s size, the more significant the price impact, leading to slippage.

Fees are generally collected for liquidity providers as a reward for their service.

Centralized Exchanges (CeX) with Order Books

Centralized exchanges operate with a different structure, often utilizing market makers and order books.

Order Books: CeXs maintain an order book that lists all outstanding buy and sell orders at different price levels. Market makers and other participants place these orders.
Market Makers/Prime Brokers: These entities aim to provide liquidity by continuously buying and selling at prices that are profitable to them. They try to balance the buy and sell orders to profit from the bid-ask spread.
Price Determination: Prices are determined through the matching of buy and sell orders in the order book.

Comparison

Control and Regulation: CeXs are centralized and often regulated. DEXs, in contrast, are decentralized and generally beyond the control of any single entity.
Transparency: Everything happening in a DEX is visible on-chain, whereas the internals of a CeX are usually opaque to outside observers.
Accessibility and Custody: DEXs allow users to trade directly from their wallets, while CeXs require depositing funds into the exchange.
Cost and Speed: DEXs can have higher transaction costs and slower speeds due to blockchain processing times, whereas CeXs control their environments and can offer faster and sometimes cheaper trades.

Liquidity pools in DeFi are implemented using smart contracts and represent a departure from traditional order book models. The decentralized nature, accessibility, and transparency of DEXs and liquidity pools come with trade-offs in terms of efficiency and cost compared to centralized models.