Liquidity Pools

What are liquidity pools

Liquidity pools are a mechanism that allow trading between two tokens in a completely decentralized way. This is as opposed to the traditional method which is managed by a centralized market maker who matches orders to buy and sell in an order book (think going to the bank to exchange dollars for euros). Liquidity pools use smart contracts instead of the centralized market maker. They determine the asset prices with an algorithm that takes into account the ratio between the two tokens in the liquidity pool. Because this all happens automatically, they are called ‘Automated Market Makers’, or in short: AMMs.

Imagine a bowl where you put in two different currencies: dollars and euros. The bowl is left out in the open so that anyone can trade dollars for euros, whenever they want. Trading costs a small fee, which goes to reward the people who provided the liquidity. Anyone can add dollars and euros (i,e liquidity) to the bowl and receive their fair share of the reward fee. Because all of this runs on open source code, anyone can create a pool between any two assets.

How liquidity pools work

Their are three main components to a liquidity pool:

1. Providing liquidity: what tokens will trade with each other
2. Setting the price of the tokens: the pricing algorithm
3. Rewarding liquidity providers (LPs)

Liquidity pools: providing liquidity

Liquidity pools can be set up by anyone using protocols such . Every blockchain has its most popular AMM protocol as well as some competitors. Pools are established by depositing two different tokens into the pool. The tokens can then be swapped with each other. For example depositing ETH and USDC into a new liquidity pool will create a pool where one can trade ETH with USDC.

CREATING A LIQUIDITY POOL IS RISKY

Creating a liquidity pool implies that the price of our token will fluctuate. It is very important that we are aware of the risk involved, since if the price sinks too much, our project will probably have the same result.

Think if this is the best option or other options are better for us. We recommend creating a liquidity pool if we are sure that we can maintain a healthy economy.

CREATING A LIQUIDITY POOL IS NOT FREE

To create a liquidity pool we must deposit tokens, and usually one of them will be a Stablecoin or a Token such as ETH, SOL, MATIC or BNB, so we must make an investment in adding enough liquidity if we want it to be maintained.

In addition, the creation of this liquidity pool in an exchange is not free. We will have to pay certain fees that vary depending on the lockchain where we create the liquidity pool.

IMPORTANCE OF CREATING LIQUIDITY WITH STABLECOIN

We must understand that when we create a token pair with a token whose price fluctuates, the price of our token will also fluctuate. That is why it is important to take this into account and decide whether it is more convenient for us to create liquidity with a stablecoin.

If we use a stablecoin, its price will not fluctuate, so the price of our token will depend on its demand. The more purchases, the price will go up, the more sales, the price will go down.