Understanding Liquidity and How to Measure It

For example, a person can become a liquidity provider on Uniswap (a Decentralized Exchange (DEX)) and deposit his assets into Uniswap’s liquidity Pool. Further, traders use Uniswap to buy or sell crypto tokens, and in exchange for that, Uniswap charges a trading fee. Uniswap distributes this trading fee to its Liquidity Providers as a reward for providing liquidity to the platform. Curve pools, by implementing a slightly different algorithm, are able to offer lower fees and lower slippage when exchanging these tokens. In essence, market makers are entities that facilitate trading by always willing to buy or sell a particular asset.

These rewards are in the form of special LP (Liquidity Provider) tokens, which can sometimes be staked to further increase returns. Providing liquidity can thus be a stable source of income for many investors. The first technology to understand before delving into liquidity pools is smart contracts. Smart contracts https://www.xcritical.in/blog/what-is-liquidity-mining/ are sets of code on a blockchain that execute automatically when their conditions are met. First popularized by Ethereum in 2015, they now form the backbone of all decentralized applications, particularly in the DeFi space. DeFi liquidity is typically expressed in terms of total value locked (TVL).

But you must be wondering why does someone want to supply their assets owned in their wallet and risk the same. Decentralized trading protocols cannot rely on Order books and manual market makers, to support their trading needs. In conclusion, a liquidity pool in crypto is a great opportunity to consider when making investment decisions. While it has some drawbacks, such as the potential for bubbles and crashes, its benefits include increased efficiency in financial markets and more opportunities for investors. By understanding what a liquidity pool is and how it works, you can make better-informed choices about your investments.

For example, a liquidity pool can contain ETH and an ERC-20 token like USDT, both of which will be available on the exchange. For every pool created, the first provider provides the initial price of available assets in the pool. This initial liquidity provider sets an equal value of both tokens to the pool.


Instead, the platforms leverage the liquidity pool with the locked-in assets. Trades can occur with limited slippage regardless of the illiquidity levels of the trading pairs as long as the liquidity pool has sufficient funds. The main difference between these two concepts is that yield farming provides a stable, passive income stream, while liquidity pools offer more opportunities for immediate gains and losses. Liquidity pools also tend to be riskier, as they involve exchanging one token for another and exposing yourself to the volatility of the cryptocurrency market. However, liquidity pools can also offer greater rewards if you correctly predict which tokens will appreciate in value. Curve Finance is a liquidity pool provider that allows users to trade directly from their wallet, without having to go through an exchange.

  • In the 1990s, HFT became so pervasive that it grew increasingly difficult to execute large trades through a single exchange.
  • He has a bachelor’s degree in Mechatronics and a keen interest in the FinTech space.
  • Software evangelist for blockchain technologies; reducing friction in online transactions, bridging gaps between marketing, sales and customer success.
  • Moreover, broker fees tend to be quite large (e.g., 5% to 7% on average for a real estate agent).
  • Whether it’s a low cap cryptocurrency or penny stock, slippage will be a concern when trying to enter — or exit — any trade.

The main reason for this is that the algorithm asymptotically increases the price of the token as the desired quantity increases. The math behind the constant product market maker is pretty interesting, but to make sure this article is not too long, I’ll save it for another time. As mentioned above, a typical liquidity pool motivates and rewards its users for staking their digital assets in a pool. Rewards can come in the form of crypto rewards or a fraction of trading fees from exchanges where they pool their assets in.


Instead, your activity is managed by the algorithm that governs what happens in the pool. In addition, pricing is also determined by this algorithm based on the trades that happen in the pool. DeFi trading, however, involves executing trades on-chain, without a centralized party holding the funds. Each interaction with the order book requires gas fees, which makes it much more expensive to execute trades. The system that matches orders with each other is called the matching engine. Along with the matching engine, the order book is the core of any centralized exchange (CEX).

Both borrower and lender reap rewards for empowering this financial engine. Liquidity pool is one such core concept lying at the heart of Defi world, which we will deep dive into and explore https://www.xcritical.in/ together. In the business world, there are a variety of financial terms that can be confusing for newcomers. One term you may have heard is “liquidity pool.” But what is a liquidity pool?

Understanding Liquidity

If the buyer wants to buy, they don’t have to rely on a seller at the specific moment. On the contrary, adequate liquidity in the pool could support the execution of the trade. DeversiFi is a company that provides liquidity pool services through the Ethereum blockchain. This allows users to trade cryptocurrencies without needing to go through a centralized exchange.

Investors, then, will not have to give up unrealized gains for a quick sale. When the spread between the bid and ask prices tightens, the market is more liquid; when it grows, the market instead becomes more illiquid. The liquidity of markets for other assets, such as derivatives, contracts, currencies, or commodities, often depends on their size and how many open exchanges exist for them to be traded on.

Let me know the projects or concepts that you would like me to cover on CoinSutra. Decentralised finance (DeFi) is a movement that aims to disrupt the current traditional… Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism.

Thus, the structure of a pool is something that is decided by the platform itself. The term liquidity provider is a generic term and can be used differently on a different platform. According to KPMG, the major levers of liquidity provider returns are divergence losses or impermanent losses and capital efficiency of liquidity provided.

Cryptopedia does not guarantee the reliability of the Site content and shall not be held liable for any errors, omissions, or inaccuracies. The opinions and views expressed in any Cryptopedia article are solely those of the author(s) and do not reflect the opinions of Gemini or its management. A qualified professional should be consulted prior to making financial decisions. In exchange for providing liquidity, Uniswap would give LP Tokens (Liquidity Provider Tokens) to the Liquidity Provider.

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