Understanding Liquidity and Liquidity pools

  • The body — limits of the liquidity pool
  • The rods — liquidity providers
  • The beads — liquidity
Liquidity Pools — Open Finance

The LPs and liquidity mechanics

Liquidity Providers (LPs) are the main driving forces behind an Automated Market Maker (AMM) DEX, as they are the ones that provide both tokens (and in some cases up to 8 different tokens) for the shared liquidity pool so that users can trade against them and get rewarded with the fees that users pay for trading.

Visualization of a trade on an AMM

A short example

If it sounds a bit confusing, don’t worry we will take a small example to showcase how a trade usually works on an AMM.

A more in-depth view of price impact and slippage

The bigger the trade the larger the liquidity engaged, thus creating a bigger price impact for the user.

The dangers of Impermanent Loss

Impermanent loss (IL) is something that affects virtually every AMM DEX Liquidity Provider (LP), but very few know how to gauge the impact of it for their LP positions.

Possible evolution of the two token prices in this scenario
  • 1.25x price change = 0.6% loss
  • 1.50x price change = 2.0% loss
  • 1.75x price change = 3.8% loss
  • 2x price change = 5.7% loss
  • 3x price change = 13.4% loss
  • 4x price change = 20.0% loss
  • 5x price change = 25.5% loss
  1. The good one, where token prices fluctuate around the same price or increase/decrease at the same rate.
The situations favorable to LPs
The situations unfavorable to LPs

Conclusion

The AMM concept introduced a whole new vertical for the decentralized financial world and opened the space to anyone to become a market maker on their own with the help of a clever Liquidity managing system. As such the new Liquidity providers can benefit from their holdings by locking their tokens into a pool to be used as liquidity for other participants to trade against.

For more information, please visit us:

--

--

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store
Istari Vision

Istari Vision

Trusted Staking-as-a-Service Provider