Crypto liquidity pools are an essential element of the DeFi ecosystem. In their simplest form, a crypto liquidity pool is a bunch of digital currencies or tokens locked in a smart contract. These pools aid in facilitating decentralized trading to help lower the risk of slippage, among other functions. (See ‘Advantages of a Crypto Liquidity Pool’ below).
Want to advance your digital funds investments and trading strategies? Learn all about crypto liquidity pools and how to use them to their full advantage.
What Does Liquidity Mean in Cryptocurrency?
Liquidity in cryptocurrency is how easy it is to convert your cryptocurrency to cash or another asset without impacting its price. This means that you can turn your cryptocurrency into a fair cash value quickly.
Cryptocurrency with high liquidity refers to one that you can easily buy and sell without impacting its price. Cryptocurrency with low liquidity refers to an asset that you cannot easily buy and sell or that would result in significant impacts on the cryptocurrency’s price.
How Do Crypto Liquidity Pools Work?
A liquidity pool consists of 2 cryptocurrencies or tokens. Pools create different markets for a pair of tokens. The originator of each new pool sets the starting price for that asset. But if that price for the pool is not in line with the global crypto marketplace, the liquidity provider can lose its capital. Keeping tokens in line with market prices as more providers add funds to the pool is important.
As the liquidity pool facilitates token swaps, the price will adjust based on a pricing algorithm. Each liquidity pool might use its own algorithm to calculate the value. The algorithm ensures that the pool always has liquidity no matter the size of a trade. These are frequently called Automated Market Makers (AMMs). [Learn more: What is AMM?]
The token ratio governs the pool’s price. For example, in the DAI/ETH pool, if someone buys DAI from the pool, that increases the volume of ETH, which increases the price of DAI and decreases the price of ETH. The total change in price will vary based on how much the person bought and how much it changed the pool. Larger pools see fewer fluctuations because it takes very large trades and purchases for changes to occur.
The liquidity providers earn money from the transaction fees for others to buy and sell from the pool. Those transaction fees go back into the liquidity pool to further increase the value of your tokens and aid in growing the pool.
Established liquidity pools can have well over $1 million invested, which makes them fairly stable for new traders looking to get started with crypto. Smaller pools can be more susceptible to fluctuations in the market, which can mean that the value of your tokens decreases. With the right pool, you can enjoy excellent value stability while earning transaction fees to increase your original investment.
What Is a Liquidity Pool in Cryptocurrency?
A crypto pool is a set of tokens that are locked in smart contracts. They facilitate trades between the assets in decentralized exchanges to provide a more balanced and stable trading, buying, and selling process.
Are Liquidity Pools Profitable?
Yes, participating in liquidity pools can be profitable. Individuals who place funds in a liquidity pool earn from trading fees based on the percent of the liquidity pool they own.
How Do Liquidity Pools Make Money?
When an investor supplies liquidity to a pool, that individual makes money by allowing others to use that liquidity for transactions. The investor supplying the liquidity earns a percentage of every trade.
What Are the Best Liquidity Pools?
The best liquidity pools are those that are large enough to limit risks and large fluctuations, have a long history, good daily volume, and large reserves. Some of the best liquidity pools are BTC/USDT, DAI/USDC/USDT, renBTC/WBTC, renBTC/WBTC/sBTC, HBTC/WBTC, WETH/USDT, USDC/WETH.
Are Liquidity Pools Regulated?
To create a pool, the investment fund manager must have a license. The pool also requires an investment fund license in any jurisdiction where the pool is actively offered or advertised to clients.
Some liquidity pools for crypto get around this by creating governance tokens and viewing the pool as community-owned. That way, regulators cannot take the owners to court since an entire community is the owner. However, taking part in pools like these can be high risk. Before joining a liquidity pool, learn more about its governance and compliance with applicable regulations.
Example DeFi Liquidity Pools
Within the decentralized trading space, there are hundreds of liquidity pools and many platforms that provide access to those pools. Apifiny HEX is designed to offer traders no taker fees with the comfort of knowing you won’t face regulatory challenges due to the platform’s KYC and AML compliance procedures. HEX liquidity providers enjoy the same level of compliance along with zero gas fees.
Advantages of a Crypto Liquidity Pool
A liquidity crypto pool has many great advantages for managers, investors and traders. These advantages can include the following.
- Ensures there is enough liquidity to meet DeFi protocols
- Anyone can provide liquidity to these pools
- Provides many layers of earning potential
- Earning a governance token can provide voting rights to oversee decision-making concerning the pool
- Users maintain control of their digital assets
How Risky Is Providing Liquidity in Crypto?
Liquidity pools in crypto do carry some risk with them. That’s because you’re buying into a contract with a temporary custodian of your funds. Should that contract suffer a bug, hack, or other failures, you’ll lose your investment.
Another risk with liquidity pools is that you could lose access to the platform, thereby losing access to your funds. This more commonly occurs on platforms that require an admin key.
To lower your risk, you should carefully select the decentralized platforms where you invest your money, regardless of whether you’re looking at liquidity pools or other investment strategies.
One risk that is platform agnostic is the risk of extreme price fluctuation. The dollar value of the deposited token could change as the assets in the pool change. Once you withdraw your token, it could be worth far less than when you started. However, if you’ve invested in a good pool, it’s unlikely that you’ll lose money overall due to the pool rewards you’ll earn.
Liquidity Pools vs Staking
Liquidity pools and staking are both terms used within decentralized finance and have several similarities. Both refer to an individual investing in applications or functions that require capital, such as a decentralized exchange, blockchain, or mutual insurance alternative.
However, they are two separate investment strategies that you should know and understand their differences.
In staking, you put up collateral to pay into a protocol you’re supporting. This activity involves investing native tokens in return for brand new ones that you keep within that special wallet long term to earn annual interest on them for the duration they are locked within that wallet.
In contrast, users deposit pairs of tokens into a liquidity pool. While your tokens are in that pool, other users can trade, borrow, or otherwise use the tokens for their own purposes. The individuals using your tokens pay a fee per transaction. Those fees are then paid to the liquidity providers who originally invested their token pairs.
Liquidity pools vs. staking each have their advantages and disadvantages based on the risk you’re willing to assume and your investment preferences. Generally, staking requires a large investment, which not everyone has. But staking can be less risky than liquidity pools.
Start Earning Passive Crypto Income with Liquidity Pools
Liquidity pools offer an excellent way to earn passive income with crypto. The first step is selecting a good platform and selecting the best pools for stable and secure income.
Apifiny HEX is designed to provide access to provide liquidity and earn market making income from regulated and compliant liquidity pools. And best of all, there are ZERO gas fees. Create an account now to get started.