Liquidity Pools in Brief

If you have already read the post called “DeFi – Decentralized Finance” on our Blog site at Compumatrix.ph, you are somewhat familiar with the following already.

Liquidity chiefly affects the fluctuation price of an asset. Liquidity is the “readily available” amount of assets in a given market. Due to the high volatile quality of Cryptocurrencies, liquidity does have a distinct effect on the crypto markets and traditional markets.


As it is explained in the Compumatrix Newsletter https://compumatrix.substack.com/p/compumatrix-automated-liquidity-pool

What is a liquidity pool?

“A liquidity pool is a vault where market participants place their assets together to provide a large pool of liquidity for anyone looking to swap an asset in a trading pair. The pool makers become liquidity miners and receive passive income in proportion to their contribution to the pool. Automated Market Maker AMM is used instead of order book and market maker services, distributing income from trading activity among all pool makers.”


What is Automated Market Maker (AMM)?

(definition from Wikipedia) “Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading was developed to make use of the speed and data processing advantages that computers have over human traders.”


Understanding concepts of DEFI and how liquidity pools in DEFI are envisioned to perform.

In Decentralized Finance (DeFi), Liquidity pools are an assembled group of tokens (assets) secured in smart contracts. They promote simple trading of assets in the pool, which obliges the pool assets owners to earn a yield depending on the number of assets they pool. Simply put, a liquidity pool is an Automated Market Maker that provides liquidity. This, in turn, cuts down on huge price swings of an asset.

Why does DeFi need liquidity pools in the first place?  The typical order-book system used on the standard crypto trading sites won’t typically work for DEFI. WHY? The old order-book model depends largely on the individual market-makers to keep the liquidity up. When no one is trading in the market, the exchange becomes “illiquid” or stale.

Yes, the old order-book system model works well IF enough buyers and sellers continuously utilize the market. When there is not enough activity in a market (causing little to no liquidity), the asset becomes illiquid and difficult to buy and sell. This can cause some extreme price fluctuations and sell-offs of large individual transactions. Resulting in an asset’s unlikeliness of being adopted.


How do Liquidity Pools Work?

Algorithms called Automated Market Makers (AMM) dispense continuous liquidity from the pools for market trading.

  • The pool’s creator sets the initial price of the assets in the pool.
  • A liquidity pool holds a pair of assets, and the pool creator initiates a new market for that pair of assets.
  • Liquidity Pool contributors are incentivized to render equal amounts of both assets to the pool. EXAMPLE – equal amounts of BTS and CBTC, depending on current market values for each asset.
  • Liquidity Pool contributors receive tokens (called LP tokens) to show ownership equal to the amounts of assets they contribute.
  • A 0.3% fee is levied and divided equally depending on the number of LP tokens a contributor holds. (example)

What Happens When a Swap Takes Place in a Pool?

When one of the assets in a liquidity Pool is traded or swapped, the supply of one decreases while the other increases. Therefore, the algorithm adjusts the price changes, and this is called Automated Market Making (AMM.)

This is where Liquidity Pools exhibit their best roles as no professional third party (centralized market maker) is needed to manage the prices of the assets. Liquidity Pool contributors deposit their assets into the pool, and the smart contract sets the prices.


Information on Compumatrix Newsletter regarding the DEFI Project:

How does it work?

Each swap of assets that pass through the Automated Market Maker (AMM) of liquidity pool leads to a movement in the asset price. The AMM uses a constant product model to automatically calculate the price and the user only needs to enter the amount. The exchange operation can be performed by the user at any time. Also, it requires 5 BTS as a fee to output an asset.

After sending tokens to the pool, the makers receive special tokens (LP tokens) – in proportion to how much of the liquidity they provided. When a swap takes place in which the pool participates, AMM collects a fee and distributes it among all the participants in the pool, in proportion to their share. Also, during transactions, an asset market fee is charged. Distribution formula: liquidity pool fee 0.2% + 0.1% asset market fee = 0.3%, excluding slippage. Fee 0.2% is allocated according to the share of each liquidity maker in the pool.

If you have spare assets, you can provide liquidity to earn interest. The constant (A x B = K) works as the product of the number of both assets in the pool. Thus, the pool can always provide liquidity. The less A tokens remain, the more expensive they become, and the cheaper the B tokens become. If someone buys a lot of CBTC in a CBTC / BTS pair, he decreases the BTS pool and increases the CBTC pool, which immediately affects the exchange rate. The larger the pool volume in relation to the size of the swap, the less this swap affects the price.


Additional Information from https://finematics.com/

The main takeaway here is that the ratio of the tokens in the pool dictates the price, so if someone, let’s say, buys ETH from a DAI/ETH pool they reduce the supply of ETH and add the supply of DAI which results in an increase in the price of ETH and a decrease in the price of DAI. How much the price moves depends on the size of the trade, in proportion to the size of the pool. The bigger the pool is in comparison to trade, the lesser the price impact a.k.a slippage occurs, so large pools can accommodate bigger trades without moving the price too much.

Because larger liquidity pools create less slippage and result in a better trading experience, some protocols like Balancer started incentivising liquidity providers with extra tokens for supplying liquidity to certain pools. This process is called liquidity mining…

The concepts behind liquidity pools and automated market-making are quite simple yet extremely powerful as we don’t have to have a centralized order book anymore and we don’t have to rely on external market makers to constantly keep providing liquidity to an exchange.

Risks

And of course, like with everything in DeFi we have to remember about potential risks. Besides our standard DeFi risks like smart contract bugs, admin keys and systemic risks, we have to add 2 new ones – impairment loss and liquidity pool hacks.


Freestartupkits.com had this to add to Risks:

The downside to AMMs is that the price adjustment model has to be carefully set. If this price-adjustment model is not sensitive enough, the AMMs cash can easily run out, and if this price-adjustment model is over-sensitive, minor trades can create large undulations at the price.

These automated market makers are incentive to the liquidity (or lacking liquidity) of a market because of its “deterministic nature of price-adjustment models”. This is key because it means that trades cause prices to move the same amount in both busy and spare markets.

The benefits of the AMM are that there is always availability. AMMs makes it possible to always act as a counterparty (although the price the AMM offers could be more expensive than other exchange methods). Automated market maker smart-contracts also can easily integrate with external smart contracts.


Consider everything before taking part, as there are no guarantees.

About the author

Gail holds one of the most challenging role in the Compumatrix Leadership: Membership. She ensures that that members and potential members enjoy the benefits of being part of the Compumatrix community.

Comments

  1. Interesting post-Gail, but still not to easy to understand it in full. I think the best way to see how it works will be seeing it in action once we are able to use it. It looks like it will be a big help especially for those members who are not able to trade or not even want to. Like every other tool, it seems not to be risk-free either.
    Like you said……Consider everything before taking part, as there are no guarantees.

    1. I agree Gitta, its something new, and we need to see it in action once we are able to use it.
      It will be very interesting as a passive income, for the member that they don’t know how to trade.

  2. Gail,very informative blog! There is so much information in this blog that needs to be read and understood again and again,as far as I understand,that is, the liquidity pool automatically in the market when exchanging assets,and the price automatically uses the AMM product model,all we need to do is enter the fee, which is 5 BTS, LP tokens are used to provide liquidity,and different fees are allocated,of course, the price of AMM is very expensive, but when the benefits are many, there is no harm in paying more, trade needs to be understood. Thank you Gail for sharing very useful article.

    1. Hi, Zahra…please don’t assume the amounts of fees, costs, and profit amounts. Those will be given so that all members will understand more. Each Liquidity pool can operate differently, so we want to make sure we have all the information before starting. Keep in mind that the liquidity pool comprises TWO assets, so to participate, you would have to supply equal amounts of the two assets. (depending on which assets the focus of the Pool is on) Remember these:
      * A liquidity pool holds a pair of assets, and the pool creator initiates a new market for that pair of assets.
      * Liquidity Pool contributors are incentivized to render equal amounts of both assets to the pool. EXAMPLE – equal amounts of BTS and CBTC, depending on current market values for each asset.
      Of course, the profits come as well. And more will be discussed as that information becomes available.

  3. Gail, you are bridging the gap by helping us understand these terminologies, this is a solution to many of our members if at all they will put this into consideration, and with lots of information as to their back up. I’m learning a lot from this, it easy for me to answer questions I’m dealing with coming from my lot. Thank you again for this.

  4. Gail. all of this is finally making sense. When presented with new concepts many times we are so overwhelmed that we can’t see the forest for the trees. You have cleared a path to make this so simple. The light bulb is burning brightly as all of this is coming into focus. Your first blog on this subject piqued the interest but was a bit to chew on. This one broke it down where the actual picture is revealed and I can say, I’m in! This may be a risk but life is a risk. As we learn more on the subject and actually see this in action more light bulbs will go off. This could be the solution we have been praying for! Thank you for your constant dedication to making this business more understandable for the novices.

  5. Gail, a very good approach to the explanation of liquidity pool, but still complex in understanding to the average member that is not familiar with the trading market.
    We are hoping, that it is in interest for the company to set up simple steps, for members’ involvement. We know it is in the early stage.

    1. Any new technology MUST be understood thoroughly BEFORE a user participates. And if the user doesn’t understand it is best they do not participate. It is a given that each of us learns at a different pace so until that level of understanding is reached the user needs to keep reading and absorbing. This is an option, not mandatory!

  6. Thanks for some great info on Liquidity Pools. It really is exciting to see that we are connected with some of the most advanced platforms in the fast changing crypto world. Having insight to the pros and cons of the way it works is vital so everyone can make informed decisions to engage or not.

  7. Good to learn more on this subject. I noticed how the use of Smart Contracts are key to the trading process and that these smart contracts can also be linked to outside contracts too. DeFi Liquidity Pools is still a new concept to me and I intend watching it closely as it progresses.

  8. great info Gail — thank you — will read this multiple times to gain the understanding needed — I come here to learn the basics but am learning more than just basics and very much appreciative of the effort put in here by so many to help — be blessed always in Yeshua always — rj

  9. I will leave well alone until I am able to see which of my assets are available in the CDAP. I am not in a position to put any more money into compumatrix until all is revealed and stored info can be seen and protocols restated.

  10. The opportunities each new idea in the crypto sphere brings to us excites me! As far as DeFi, I’m going to watch from a short distance as things ground in. My intention is to truly grasp each step and what it’s for before stepping in. I’m so appreciative of the very informative blogs you write, Gail. I just keep reading & watching videos over and over until it sinks in. I’ll master this someday. The fun never ends in Cryptoland!!!

  11. We certainly cannot complain that we aren’t being given information for the cryptocurrency business! Even though for some it may be hard to comprehend, that onus is on our shoulders. For me, at this moment I would be uncertain even with only dipping a toe into the pool! Perhaps this comes from never learning to swim at an early age due to lack of any water around our farm except puddles 🙂 What I really love about Compumatrix is that we have options – there’s something for everyone!

  12. “What is Automated Market Maker (AMM)?
    (definition from Wikipedia) “Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading was developed to make use of the speed and data processing advantages that computers have over human traders.”

    Am I correct in assuming that AMM is a “modified BOT” ?

  13. Well done, Gail! Another informative and educational blog from you. The old cliches of ‘you are never too old to learn’, and ‘you learn something new everyday’, certainly apply to this complex cryptocurrency world we are diving into. Of course many of us will take much longer to understand the whole picture than others, but in the meantime, learning and understanding one facet at a time is sufficient until we can put it all together to create a whole new understanding.

  14. Thanks for the explanation Gail. I read it through twice and I am guessing this is a really good way to protect the value of one’s assets. Am I right in thinking that this will prevent people from trading our assets down to pennies? I am “defi’nitely” going to give this a try on a small scale at first, until I know what I am doing. While I was reading your post I thought of the words of Richard Branson, “If somebody offers you an amazing opportunity but you are not sure you can do it, SAY YES then learn how to do it later!”

  15. New terminology DEFI. AMM, and now Liquidity pool; brings new study for me to understand. Now that I’m getting used to Blockchain and Bitcoin.
    Sounds like something we can all benefit from it IF we follow rightly what is required. A platform that is based on decentralization DEX with Moneymakers (Automated) creating markets and a pool (Liquidity) where there’s always assets to trade.
    Thanks, Gail.

  16. Thank you for the blog on DeFi Gail, reading your examples on how the pools work is very interesting. I’ve been watching some videos also, so I can understand how this all works too. It’s starting to make more sense every time I read or watch something on DeFi. I’m looking forward to putting all this information into gear, standing by.

  17. Thanks, Gail for the clear concise explanation of Liquidity Pools. I also appreciate the reminder of the information found in the newsletter regarding the DEFI Project. The more I read the more I learn about the entire process. One does need to pay attention to the risks involved before jumping in with both feet.

  18. Trying to comprehend all that is involved with Liquidity Pools. Seems like everyday there is another way to earn or grow interest which is fine but, I feel like I need to wait for Henry and see all that he has in the back room. If you spend all day looking at all the ways to achieve more revenue, it can be mind boggling. Not understanding all of the process with the pools is learning how and if the risk is small. Will hold off for now but will keep trying to learn the process. Thanks Gail and my fellow travelers for your input.

  19. Very interesting and informative post Gail. I am so glad you broke that all down for us in easy to understand language. So many of us are not schooled in these things, and we are really learning new things all the time about the crypto world. I don’t understand smart contracts as much as I would like to, but I see how important they are now in our crypto world.

  20. Very refreshing blog It does break it down to better understanding but I would continue with caution not to put too much in at one time, you may be better off to hold for a while to check out the results and then try a little more this is a learning curve for all of us but does sound very interesting looking forward to getting started.

  21. There is so much information in this blog that I had to read it 3 times for me to try to understand and I’m still not sure that I do. Also I’ve been watching some videos so I can understand how this all works. It’s starting to make more sense every time I read or watch something on DeFi. I’m looking forward to putting all this information into gear in the near future.

  22. Okay, NOW I feel I can comment on this with a little more depth of understanding! While I understand the basic, general premise behind liquidity pools and how they work, it took a few reads to “see” it from different angles and how it enhances our overall position here, and wow! DeFi is a few levels of sophistication above what I’ve experienced so far. It’s very reassuring and admirable how this “AMM” has been figured out, configured to fit our market system and is meticulously tying it all together! Exciting to get a clearer picture about the mechanics of this “machine”! 🙂

  23. Gail, thank you for this blog explaining in a precise method about the liquidity pools. The information you give is essential and comprehended by those who trade in cryptocurrencies. That is not me, but your grafts and pictures help me to understand a little more. There will be an AHA moment for me. It will put a smile on my face, a joy in my heart, as clarity settles in my mind.

  24. I almost now consider myself a genius just because I was able to read your post and somewhat comprehend what I just read. Subjects like this seem to almost always require more than one read on the subject to get a good grasp and then retain what you have just read. But it strange how it seems to always be worth the time. Now that I have a greater understanding of DeFi, it certainly hold more interest for me. However, slow as I go will rule the day until this sinks in a bit more into this “genius” brain.

  25. Thank you so much, Gail, for your great blogs. I understand about liquidity pools a little more, but I’ll have to reread this. There’s so much information I feel I always need to soak yours up. And I love the videos you suggested you were teaching the grandkids. They are excellent as well.

  26. this is such a great posting and the info in this is so solid — yeppers have read this 4 times now and know won’t just jump in — there is so many active parts in the defi Crypto compu world and making a plan and sticking to that plan is difficult because the playing field changes almost daily it seems — so start small with pro understanding n help — keep teaching Gail n thank you Ma’am

  27. Thank you for this interesting read Gail. It is a very interesting subject you write about but it is also rather complex. It is certainly something worthwhile to read about more. And also to see it works in reality. I think the best way to see it work is to start doing it. With small amounts.

  28. I must admit , I am not quite understanding DeFi ,a few things I get but there is so much to sink ones mind into this when I read the info you blogged about in here Gail. I read it twice .but I feel I have to go back and jump into the unknown again and see what happens this time. See if that light bulb gets turned on this time.

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