Crypto Liquidity Pools

Liquidity pools facilitate the trading of tokens on decentralized exchanges (DEXs). These pools enhance liquidity by allowing users to trade tokens without relying on a traditional order book model.

To create a liquidity pool, users must contribute an equal value of two different tokens to the pool. For example, if you want to create a pool for Token A and Token B, you would deposit an equal value of both tokens. These tokens are then locked in a smart contract, forming the liquidity pool.

Liquidity pools on DEXs utilize an Automated Market Maker algorithm, such as the Constant Product Market Maker (e.g., Uniswap's formula). This algorithm maintains track of the number of tokens in the pool, which determines how many of one token are traded for the other or essentially the price at which tokens are traded. As tokens are traded, the pool's ratio of Token A to Token B adjusts dynamically.

When users trade tokens using the liquidity pool, the trade's size affects the token prices. As more of Token A is bought, its price increases while reducing the available supply. Simultaneously, the increased supply of Token B decreases its price. The price impact is proportional to the trade size relative to the pool's liquidity.

Some decentralized exchanges like pancakeswap.finance or apeswap.finance create their own tokens to reward people for adding tokens to liquidity pools on their website. By staking their tokens in the pool, users contribute to the pool's liquidity and enable trading while being incentivized through the reward token (and possibly through a percentage of swap fees in addition to the reward token).

Keep the rewards in perspective, sometimes you’ll see estimated annual percentage yields above 100%. However, first this APY would be in the crypto itself and if the value of this crypto goes down, it wouldn’t be a true 100% APY when looking at it’s value in US Dollars for example. Also, these pools with large APY rewards, as more people stake crypto in the pools, the reward APY usually goes down as these websites only provide a set number of reward tokens a day to allocate to the entire pool as more people enter the pool, if the number and value of rewards stays the same, the proportionate returns decrease.

Price swings in one token can impact the composition of the liquidity pool. If the price of Token A experiences a drastic increase, more traders may sell Token A for Token B to capitalize on the price movement. As a result, the pool's ratio of Token A to Token B will shift, leading to a change in the price at which tokens are traded.

Owning both tokens in a liquidity pair provides some protection against drastic price drops in one token in the pair. If you owned Token A and Token B separately, the value of your holdings could be more vulnerable to individual token price movements. However, by providing liquidity to the pool, the value of your liquidity pair would experience less of a drop, as the proportional change in both Token A and Token B offsets some of the price fluctuations.

Liquidity pools play a crucial role in decentralized trading by ensuring sufficient liquidity and enabling users to trade tokens easily. By contributing to liquidity pools, users can earn rewards. However if the value of one token in the pair drastically rises and the other one stays the same, you would have made more money holding the tokens separately.