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The liquidity provider will receive an amount of LP tokens in exchange for depositing his tokens into the pool. These tokens are the deposit receipts. Make sure you don't lose these LP tokens because you'll need them to get your assets out of the liquidity pool.

What are Liquidity Pools?

Liquidity pools (LP) are a type of smart contract that manages a pool of tokens. Investors must deposit their tokens into pools to offer liquidity for token pairs because decentralized exchanges (DEXes) do not provide liquidity. This allows traders to exchange tokens from different token pairs. Liquidity pools are essentially the trading part of a decentralized exchange.

How does a Liquidity Pool work?
Two or more tokens are always present in a liquidity pool. Each liquidity pool establishes a market for its assets. On Polygon, MATIC/ETH is an example of a popular liquidity pool.

If a liquidity pool for a given token pair does not yet exist, one can be formed using a DEX. Liquidity providers must contribute both token contract addresses and tokens to the liquidity pool in order to do so. DEXs strive for a 50/50 token ratio in their liquidity pools. In our Polygon example, this means that liquidity providers must deposit the equivalent amount of MATIC and ETH into the liquidity pool.

The liquidity provider will receive an amount of LP tokens in exchange for depositing his tokens into the pool. These tokens are the deposit receipts. Make sure you don't lose these LP tokens because you'll need them to get your assets out of the liquidity pool.

A specific amount (typically 0.25 percent) of every transaction  in the liquidity pool goes to the LP token holders.

Any token swap within a liquidity pool will result in a price shift when using a deterministic price algorithm. An automated market maker is another name for this algorithm (AMM).

For rudimentary liquidity pools, such as the one utilized by QuickSwap, a constant commodity market maker algorithm is used, resulting in the token pair's amounts being constant. Regardless of the magnitude of the deals, this algorithm allows liquidity pools to maintain their liquidity. The fundamental reason liquidity is so essential is that it influences how an asset's price changes. In a low-liquid market, there will be a modest number of open orders on both sides of the order book. As a result, the asset's price fluctuates significantly, making it unpredictable and undesirable. Liquidity pools are a crucial aspect of the decentralized finance (DeFi) revolution for this reason.

Compared to typical exchanges, liquidity pools have various advantages:
Guaranteed liquidity: Traders will always be able to swap their assets thanks to the AMM algorithm, as long as the Liquidity Providers have deposited enough liquidity.
Anyone has the ability to provide liquidity: Liquidity pools, unlike centralized exchanges, do not require KYCs, listing fees, or other stumbling hurdles. When an investor decides to supply liquidity, he simply deposits his assets in the liquidity pool.
Gas prices can be maintained to a bare minimum because DEXs like QuickSwap use smart contracts.

Impermanent Loss
It's crucial to understand how impermanent losses work before you start giving liquidity to liquidity pools.

Assume an investor has put $100 worth of Matic and $100 worth of ETH tokens into a Swap's 50/50 liquidity pool. The ratio between the tokens and their prices fluctuates after the deposit, which is due to market volatility and trade. As a result, there may be more Matic in the liquidity pool than ETH at any given time, or vice versa.
Trading fees assist to mitigate the impact of temporary loss, thus it's crucial to look at the APYs of liquidity pools. The greater the APY, the less likely you are to lose money in the liquidity pool.

Conclusion
Liquidity pools are very important in DeFi. They enable investors to exchange tokens while giving liquidity providers the option to earn from transaction fees. To offer liquidity in a pool, investors are not required to meet specified criteria. Novice investors can simply start providing liquidity or swap tokens from various liquidity pools thanks to easy-to-use platforms like SushiSwap.

Written By

Petrache Ionut

Jun 16, 2022