🌊Liquidity Pools Explained
What Are DeFi Liquidity Pools?
If you've heard of decentralize exchanges (DEXes), chances are you may have heard of liquidity pools as well. Liquidity pools are what make DEXes functional. They are the foundation on which DEXes are built.
A liquidity pool in the DeFi world is a collection of cryptoassets locked in a smart contract. Liquidity providers are users who put an equal value of two cryptoassest into the liquidity pool, therefore creating a market. Essentially, the more people who put their cryptoassets into these pools, the more people are able to make trades. If the liquidity pool is small, meaning only a little bit of funds are in the pool, it won't be very practical for doing trades. If the liquidity pool is large, meaning a lot of cryptoassets are in the pool, this means many people will be able to use the DEX for swaps/trades.
For example, if you are swapping BTC to RUNE, there will need to be enough BTC and RUNE in the liquidity pool to be transferred to the user performing the swap. The more funds in the pool, the higher the trade limit as well as more people being able to do the same swap in a short period of time. Larger liquidity pools also means less slippage and better trade rates. You may be wondering why anyone would want to put cryptoassets into these pools. Liquidity providers who deposit their assets in liquidity pools generate yield in return.
Slippage:
Since market prices are constantly changing, your trade rate is likely to fluctuate. For example, by the time blocks confirm and your trade executes, the price in ETH may have gone up in price. This happens in the stock market as well as the crypto market. ShapeShift allows you to set the maximum amount of slippage for any trade you initiate. Simply select the highest percentage you will allow to account for market slippage.
Price Impact:
Price Impact is the effect a Buy or Sell Order has on the automated market maker (AMM). The bigger the trade, the bigger the effect on the AMM.
Example: A large order to buy BTC will drive the price of BTC up and conversely a large order to sell would result in the price going down (within the specific DEX you are trading with).
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More information on Liquidity Pools can be found here:
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