DeFi 101_ 6. Introduction to Liquidity Managers with @HawksightCo.mp3
Liquidity pool A liquidity pool is essentially a large pool of funds to which people can contribute, enabling others to easily exchange one type of currency for another. Typically, when you want to sell something, you need to wait for a buyer, or when you’re looking to buy, you're waiting for someone to list an asset. The same process occurs with order books in crypto, which are large "books" of potential buy and sell orders. When an order is matched, the exchange happens.
Why are liquidity pools so special? Liquidity pools are special because they eliminate the need for waiting times typically associated with buy and sell matching and transactions can occur instantly. These pools usually contain two assets, allowing anyone to exchange these assets at any time. For example, if you want to sell Solana for USDC, you can simply deposit SOL into the liquidity pool and instantly receive USDC in exchange—and vice versa. This immediate transaction is facilitated because all the funds are already available within the pool. Specifically, SOL is added to the SOL pool while USDC is deducted from the USDC pool, enabling seamless trades.
They also play an important role in maintaining market stability, as they incentivize users to deposit their assets by offering rewards derived from transaction fees or other incentive mechanisms which ensures constant liquidity but also decentralizes the control over market pricing, which is typically managed by market makers in traditional finance.
How does the money comes into the liquidity pool? Remember in previous lessons where we addressed how Binance order books work? The system allows only institutions with a LOT of money (who also meet other criteria and rules) to provide liquidity to the market. In contrast, in Web3, anyone with any amount of capital can provide liquidity to these pools, enabling trading to occur. However, remember that a pool is not just for you, it can grow significantly in terms of capital if more people deposit their money to provide liquidity. The larger the pool, the deeper the liquidity that is accessible, which also means that larger swaps (for example, exchanging 200k USDC for Solana) can be performed without greatly impacting the price.
How do you make money by providing liquidity? By placing your money inside a liquidity pool so that others can perform swaps, you earn a fee with every trade that occurs in the pool. The larger the trade, the greater the fees you collect. Consider this: when you trade on major exchanges like Coinbase or Binance, you might notice a small fee for each swap, known as a 'platform fee.' This fee is essentially paid to the liquidity providers. In decentralized apps (dApps) within Web3, where you provide liquidity, you earn this 'platform fee' directly. However, there are risks associated with this activity, including one known as 'impermanent loss'.