DeFi Education

What is a Liquidity Pool?

A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to make trades between those assets on a decentralized exchange.

What is a Liquidity Pool?


A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to make trades between those assets on a decentralized exchange. Liquidity pools are the backbone of many decentralized exchanges (DEX), such as Uniswap, Sushiswap, or Rytell. As anyone can be a liquidity provider, AMMs have made “market-making” more accessible.

How do Liquidity Pools Work?


Liquidity providers (LPs) add an equal value of two tokens in order to join an existing pool or to create a new one. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.

What are Liquidity Providers?


A liquidity provider is a user who deposits tokens into a liquidity pool. In return for supplying liquidity, users are typically awarded liquidity provider (LP) tokens that represent the share of the liquidity pool the user owns.
Liquidity providers are rewarded in proportion to the amount of liquidity they supply to the Liquidity Pool. The earnings come from the transaction fees and are proportionally distributed among all the Liquidity Providers.

What are Liquidity Provider Tokens?


Liquidity Provider Tokens (LP Tokens) are tokens issued to liquidity providers on a decentralized exchange (DEX) that run on an automated market maker (AMM) protocol to represent the share of a Liquidity Pool.

At the most basic level, LP tokens work on the following formula:

Total Value of Liquidity Pool / Circulating Supply of LP Tokens = Value of 1 LP Token

What are Liquidity Provider Tokens used for?


Liquidity Provider Tokens (LP Tokens) are used to track individual contributions to the overall liquidity pool, as LP tokens correspond proportionally to the share of liquidity in the overall pool.

These are some of the most common uses of Liquidity Provider Tokens:

  1. To determine the liquidity provider’s share of transaction fees accumulated during the duration of liquidity provision.
  2. To determine how much liquidity is returned to liquidity providers from the liquidity pools when Liquidity providers decide to redeem their LP tokens
  3. Staking LP tokens to earn further rewards as a way to incentivize Liquidity providers to lock their liquidity into pools. Usually called “Yield Farming.”
  4. Using LP tokens values as a qualifying factor to access initial DEX offering (IDOs), i.e., to participate in certain IDOs, one must hold a certain value of LP tokens.

What is Yield Farming?

Yield Farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies in liquidity pools in order to get rewards.

Yield farmers need to add liquidity in one liquidity pool in order to receive their liquidity provider tokens which they will stake to start receiving rewards on the protocol they’re adding liquidity.

or liquidity miners will typically move their funds around quite a lot between different protocols in search of high yields. As a result, DeFi platforms may also provide other economic incentives to attract more capital to their platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.

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