What is the meaning of the liquidity pool?The liquidity pool is a pile of crypto tokens locked up to facilitate the tradings of DeFi exchanges executed by smart contracts. The most common usage of liquidity pools is in automatic market makers (AMM).
Owners who supply these tokens, called liquidity providers (LPs), will receive liquidity pool tokens (LP tokens) representing the share of total assets in the pool. LPs could get rewards from trading fees which depend on the proportion of the total funds. They can also choose to bond liquidity tokens and earn passive income, known as liquidity mining.
How does a liquidity pool work?LPs choose cryptocurrencies to add liquidity to a pool through a liquidity platform or protocol like Uniswap, or Pancakeswap, and get LP tokens. The first to provide liquidity sets the tokens' initial price. Liquidity pools use AMM to determine tokens' prices with the algorithm.
To understand it better, you’d better learn total weights, pricing, and LP tokens first.
Total weightsLiquidity pools are a cluster of tokens with pre-determined weights. The weight of one token is its value that accounts for the total value in the pool (the ratio of the token value within the pool).
Uniswap pools involve 2 tokens with 50:50 weights. Other token weights are possible, such as 90–10.
For example, when you deposit Token A and Token B; let's assume, 50 Token A = 1 Token B in the value; you need to put 50 Token A and 1 Token B into the pool.
PricingPrices adjust to make the token's value relatively equal. For example, in a pool of 50:50 weights, Token A and Token B, when you buy Token A using Token B, Token A becomes less in quantity and Token B more. The price of Token A rises so that the total value of the rest of Token A will match the ratio with growing Token B. The pricing changes conform to the supply/remand rule.
More liquidity is better in the liquidity pool. It represents efficiency and speed to trade, and the price may not fluctuate much. The trading fee is associated with the portion of the tokens to be traded within the total pool. If there is much liquidity, the traded tokens may be only a little part of the pool.
LP tokensLPs receive LP tokens after depositing funds into a pool. If Pool #1 is of Token A and Token B, LPs will receive Pool#1 tokens after depositing Token A and B. It's a share token and will be destroyed after LPs withdraw their funds.
