What Is a Liquidity Pool (and Impermanent Loss)? Liquidity pools are collections of cryptocurrency tokens that enable blockchain-based trades of tokens based on fixed rules. A liquidity pool requires a pair of tokens with matching values to be supplied by individuals, known as liquidity providers. Liquidity providers, therefore, put funds into a smart contract that allows their funds to be used as liquidity for the buying and selling of the tokens in the pair. Because cryptocurrencies are often traded peer to peer, a liquidity pool is needed to ensure that transactions can occur quickly and effectively. Each transaction that uses the liquidity pool generates fees, and these fees are distributed to liquidity providers as profits or yield.
Liquidity pools are usually part of something called an Automated Market Maker (AMMs). Automated market makers were developed and made popular by Uniswap. Uniswap is a trading protocol on the Ethereum blockchain. They changed trading from a competitive winner-take-all game into a cooperative endeavour between thousands of anonymous participants who make up each liquidity pool. Old “order-book-based” decentralized exchanges became obsolete with the introduction of this system.
The core concept of the automated market maker is the Liquidity Pool, in which Liquidity Providers add 2 tokens, such as ETH and USDC and get LP tokens in return. In our example, a liquidity pool may be made up of Ethereum and USDC. These are cooperative pools- meaning that when traders trade in this pair, buy either buying or selling one of the tokens, fees are charged and split equally among participants in proportion to their contributed capital. On Uniswap V2, Pancakeswap, and Sushiswap, these liquidity pools are made of two tokens split 50/50. On other protocols such as Curve or Balancer the pools can have dynamic token balances. This video discusses the classic 50/50 liquidity pools, as these are the most common, and are made up of two assets in equal dollar value amounts to one another. Going back to our example, as ETH appreciates in value, the pool will sell some ETH and buy USDC. If ETH depreciates, the pool will buy ETH and sell USDC to traders. These actions are required to keep the 50/50 balance of value in the pool.
Liquidity Pools offer liquidity providers revenue in the form of trading fees as well as additional rewards from the token providers themselves. The combined returns can be quite high, making it attractive to private and institutional investors.
A very large driver for the performance of liquidity pools is what’s known as Impermanent Loss (IL). Impermanent loss, also referred to as divergence loss, is the unavoidable loss of value of your liquidity pool investment from any change in asset prices. The performance of these pools depends significantly on the trading volume and the underlying asset movements. The losses grow larger as prices drift away from the entry point relative to each other, whether it is appreciating or depreciating. If both assets in the liquidity pool remain exactly the same there is zero impermanent loss. However, the more the price of one token fluctuates in value compared to the other the higher the impermanent loss will be. The losses remain “impermanent” until either the coins return to their perfectly matched starting value, or the liquidity provider cashes out of the pool, and the loss becomes realized.
If you’d like to understand exactly what the impact might be of impermanent loss you can use our calculator over at https://weave.financial, to see what the potential is for impermanent loss based on different scenarios.
Because liquidity is essential for most cryptocurrencies, the projects will often highly incentivize liquidity providers with high rewards of their native token to compensate them for the potential for impermanent loss. This means that yield for liquidity providers can be very high, although it does not mean that profits are guaranteed, and losses can be made even after the high yields are accounted for, especially if one of the tokens in the pair performs badly. Choosing good quality tokens to pair is very important here, as is the yield that a pair is generating, meaning that yield farmers need to be constantly assessing the risk vs reward that a liquidity pool offers.
Whilst many people use crypto defi liquidity pool platforms such as pancake swap, uniswap, binance, sushiswap, Katana, raydium, beefy, autofarm the best liquidity pools can be found at Weave.