What is a Liquidity Pool?
Liquidity pool is a way Decentralized Exchanges (DEXs) ensure they have cryptocurrencies for exchange services. DEXs offer a liquidity pool as an investment tool to users for earning interest and pool share. A liquidity pool typically has a cryptocurrency pair like ETH-DAI, USDC-WBTC, ETH-USDT. However, some DEXs can have several cryptocurrencies in a liquidity pool. For example, a DEX, Curve Finance has a liquidity pool of stablecoins DAI-USDC-USDT-BUSD.
How does a Liquidity Pool Work?
Liquidity pools are developed using smart contracts. Its primary role is to provide liquidity to facilitate cryptocurrency exchange on a DEX. So when users swap cryptocurrencies, DEXs use liquidity from the pools to facilitate the transactions. For example, when users swap DAI for ETH, DEX will utilize the liquidity from its ETH-DAI pool. In this process, users who invested in the pool will generally lose cryptocurrencies as the whole demand increases with respect to the other token in the pair. So from our example, if ETH has more demand compared to DAI, more users will swap DAI for ETH, and the number of ETH tokens drop in the pool. However, the total value of the pool remains the same according to the pool ratio, i.e, in a 50:50 pool of ETH-DAI. The combined value of ETH and DAI remains at the same ratio but the total number of each token fluctuates with swaps.
Pool Share
Pool share is part of the fee earned by users who invest their cryptocurrencies in a liquidity pool, called Liquidity Providers (LP). For example, LPs who invest in an ETH-DAI liquidity pool earn a pool share whenever users exchange ETH for DAI, or DAI for ETH on the DEX.
Interests
Liquidity pools offer interest in APY or APR to users for investing in their cryptocurrencies. The interest rates vary with every liquidity pool and liquidity requirements of the currency pairs on a DEX. For example, low liquidity and high trading volume hypothetical tokens ABC-XYZ will have higher interest rates than popular cryptocurrency pairs like ETH-DAI.
Liquidity Pool Risks
Impermanent loss is one of the biggest risks when cryptocurrency prices rise significantly. Since more users will swap for a cryptocurrency with higher prices, LPs will end up with fewer of them in the pool, losing the opportunity to gain higher profit from the price gain. For example, if in ETH-DAI the ETH prices rise steeply, users will swap DAI for ETH and the number of ETHs will drop in the pool, affecting profits of the LPs.
As it is with any new software, DEXs are prone to hacks. However, crypto applications have evolved fairly fast after hacks and exploits.
Liquidity pools with new tokens can have temptingly high interest rates. But since most of the new tokens have failed, investing in pools with new tokens is very risky.
Related Terms
- Annual Percentage Rate (APR)
- Annual Percentage Yield (APY)
- Decentralized Exchange (DEX)
- Impermanent Loss
- Liquidity
- Liquidity Mining
- Liquidity Provider
Learn More Crypto Terms