How does liquidity pool work?
In this article read all about Nominex liquidity pools. Over the past decade, there appeared a lot of trading platforms – crypto-exchanges with the help of which investors can exchange both cryptocurrency for cryptocurrency and fiat money for cryptocurrency.
Unlike traditional exchanges, these trading platforms allow traders to have direct access to the exchange (not through a broker) and crypto. Trading takes place 24 hours a day, seven days a week. But the main advantage is that they are much less regulated than traditional exchanges. The sign up process is quite basic and a lot of them don’t even need your passport to allow you to perform transactions.
Everything needed for transactions carried out by the exchanges themselves rather than through specialized institutions. Of course, there is some control, but it is minimal while these websites are still subject to the rules of the financial world. Banks participate in mutual activities, people receive salaries, clients withdraw money through cards and so on.
Much less people and financial and investment institutions use such crypto platforms compared to those who use conventional exchanges. They have ten times less assets than, say, the stock markets. And this is us talking just about crypto. But now a new market for decentralized exchanges, decentralized assets is growing, and now you have already ceased to understand what this is about. And not only you.
Let’s figure everything out in order. The main pros that digital money provide are independence from the state or intermediaries, as well as decentralization. At the same time – here’s the bad luck – the purchase, sale of digital money, which in theory is decentralized. Mainly takes place on centralized regulated platforms, which in any case do not exist separately from the financial system.
This is where decentralized exchanges come to help the amateur conspiracy theorists, they operate on a peer-to-peer p2p network system. This means that all participants are equal and you can buy or sell currency directly from a person. The beauty of such sites is that the system is open source and, in principle, no one except the users themselves has control over the exchange.
But, the decentralized finance market is like a cube in a cube, it’s like bitcoin in bitcoin. It is even smaller. It’s even more complicated. And the question arises, which is equally obvious to the platforms themselves and to investors – how liquid are assets on such peer-to-peer trading platforms in view of all these aspects. We want to help you figure this out, as our NMX token will also soon become a representative of this asset class.
In order to answer it, one must first of all understand what this liquidity is.
Despite how complicated the language used by investors may sometimes seem, liquidity is a very simple term. Plus, you’ve probably heard of the traditional meaning of “liquidity” – the ease with which an asset converted into another asset without any problems. How high is the demand for it.
This is one of the first indicators that an investor looks at before investing in a coin or security. Low liquidity means there is volatility in the market, causing cryptocurrency prices to jump. This means that the demand for it is not stable. There are few people willing to buy or sell. Or the deal sizes are not high. There may be many reasons for this. High liquidity, however, indicates a stable market with small price jumps – the difference between the buy and sell prices. When we buy or sell something, we provide the liquidity of an asset.
You don’t need an economics degree to understand that every sale is also a purchase. If you want to exchange the Chinese yuan for the US dollar, you first need to find someone to take your yuan. Unlike traditional exchanges, the cryptocurrency market does not always have enough stock of assets in circulation – that is, there are not always enough people willing to sell it, they cannot always agree on a price, in other words, there is not always enough liquidity. And for peer-to-peer sites, these are the most important factors. For this, the so-called liquidity pools were created.
Those who already have experience in trading on crypto exchanges (for example Nominex) know that the main trading is carried out using the order book (order book, exclusive in May English). In fact, exchanges like Moscow MOEX or Tokyo JPX are based on the same principle. Buyers and sellers always want different things: buyers want to give less money, sellers want more. Therefore, both sides need to compromise and come to a common denominator.
But what if one of them is too stubborn and does not agree to anything less? What if the matter is that the tokens are simply not enough to satisfy the order? The answer is simple, and the answer is market makers.
Market makers are such large market players who support trading activity, being always ready to buy or sell any amount of a particular asset. Since they work on the principle of exchangers (due to the “spread” between the buy and sell rates), it should not be surprising that their price is based on what is more profitable for them. But thanks to the existence of market makers, you do not have to sit for days on the seller for the asset that you want to buy or the buyer for the one that you are selling.
blockchain and smart contracts
Can you use blockchain and smart contracts to create such a market maker in the field of decentralized finance? We remember, I buy from you, and you from me. That’s it – there is no one else, no one else makes money on our exchange with you.
In theory – please, you’re welcome to even become one yourself. But in practice, most likely everything will work so slowly that it will be easier to stand in line at the bank.
At the same time, the order book model is still very dependent on the presence of a market maker for each asset. Without them, the exchange loses all meaning, because convenience and liquidity suffer. Plus, you should never trust the exchange rates of market makers.
In short, the most successful concept to date has been to abandon the order book altogether. This is how decentralized liquidity pools appeared.
get back to decentralization
So let’s get back to decentralization. One of the most important concepts of decentralized finance and its liquidity are pools. One of the first projects to introduce the concept of a liquidity pool was the Bancor project. But the idea of liquidity pools gained particular popularity after the launch of the largest DeFi project Uniswap, which is essentially a huge pool of liquidity worth billions of dollars.
A liquidity pool is a kind of storage in which market participants put their assets together in order to provide a very large supply of liquidity for everyone who wants to exchange this asset but at the same time interact directly with a person without an intermediary.
decentralized smart contract
A decentralized smart contract works inside the pool, which blocks and accumulates the assets added there. This blocking of assets made to ensure trading activity (trading) and is heavily used by decentralized exchange exchanges (DEX). After all, there are few people trading on DEX. There are also few tokens traded by humans. We must ensure supply and demand! How? To make a common fund, in other words. And get the asset out of it or report to it at the same time.
So, trading these low-value assets becomes more attractive. The role of pools is to reduce the difference in supply and demand between market participants and to match people’s buy and sell orders between each other.
Types of liquidity pools
The pools that we talked about above are one of the most popular and basic types of pools that the Uniswap platform used. But other market players decided not to dwell on the existing one and began to develop new schemes for the operation of pools, creating the most interesting options.
For example, the guys from Curve were the first to decide to improve the Uniswap system, since it was not suitable for exchanging assets, the price of which should be constant, because they backed by real assets, like the US dollar. This type of asset includes stablecoins – USDT, TUSD, USDC, etc. Curve pools work according to an alternative algorithm, the sensitivity of which is less, which allows the course to remain more stable.
Another idea for the alternative operation of pools came from the Balancer protocol: the creators of the project realized that we should not limit ourselves to two types of tokens in the pool, so Balancer allows up to 8 tokens in one pool. Why 2 tokens? Good question. Pools are most often tied to currency pairs. 1 pair – 1 pool – 2 tokens.
How does Nominex liquidity pool work?
Now that it is clear why liquidity pools needed. Let’s talk in more detail about the composition of a classic liquidity pool. Why classic? Because Nominex will have a classic pool. Each liquidity pool consists of 2 tokens used to create a market for the tokens that make up the pool. Don’t panic! Let’s take an example.
For example, the Nominex liquidity pool on Uniswap contains (will contain) ERC-20 tokens: USDT, and NMX. For each pool created, the first provider provides the initial price of the available assets in the pool. This initial liquidity provider sets the same value for both tokens for the pool by pouring the same amount of NMX and USDT into it.
In the above example, NMX sets the price of the assets in the pool and provides equal value for NMX and USDT on Uniswap. Each liquidity provider (let’s call it an investor) interested in participating in the pool subsequently maintains the original ratio set for supplying tokens to the pool. By the way, if you start storing your assets in liquidity pools to increase, you automatically become a liquidity provider. Not in all cases the shares in the pools are the same, but in the case of Uniswap this is exactly the case.
So that’s it. Each time a liquidity provider contributes assets to the pool. It is provided with a unique token – the liquidity pool token. In the case of NMX and USDT, you receive the NMX-LP token. That is, the NMX Liquidity Pool token. Moreover, their number depends on how many of your assets stored in the pool.
The formula was originally incorporated into a smart contract for Uniswap. Traditionally. All holders of liquidity tokens entitled to receive a commission of 0.3%. Which is distributed depending on the amount of NMX-LP each has and charged from absolutely every transaction in the pool. For a minute, the average exchange earns from 0.05 – 0.1% from the trades of users. And also shares the interest on the referral program. And in the pool, any provider earns 3 times more from the operation than the whole exchange.
liquidity pool is a reversible process
Storing in a liquidity pool is a reversible process. By adding liquidity to the pool, you can always take the funds back. However, keep in mind that your liquidity tokens will automatically expire. Do not be afraid of this! In return, NMX and USDT will be returned to you. Remember, only 3 actions can be performed with liquidity tokens. One can receive (not bought), and returned (not sent or transferred to someone). And they can be staked – added to another smart contract on the Nominex exchange, for example.
The question arises: how the price determined in the liquidity pool? DeFi has the answer, and that’s the Automated Market Maker (AMM) engine. This has become one of the main features of DeFi, as you can see from one glance at how popular DEX based on AMM has become.
What should we expect from the industry in the future?
For anyone with the least bit of trading knowledge, AMMs are a technical solution to the rapid exchange and demand problem that early DeFi apps struggled with.
Each time a particular transaction occurs in the liquidity pool. The exchange rate moves in the direction indicated by the AMM algorithm. The details of the mechanism depend on the exchange, but they all most likely work according to the same principle: if the amount of the first token in the pool (for example, NMX) decreases, its pair (for example, with USDT) becomes more expensive.
NMX and USDT
That is, 10 NMX used to be 10 USDT, and then the balance changed and already 5 NMX cost 10 USDT, then it is logical that 1 NMX has risen in price by 2 times. If we are dealing with a sufficiently large pool, most likely such exchanges will not work and the rate will remain at the “market price” level. This is what we sought – a self-regulating mechanism in which everyone receives more or less favorable conditions.
This picture shows the 10 largest Uniswap liquidity pools. The penultimate column shows how much liquidity providers earn (hello Dudyu) per day. And the last one speaks of ROI expressed in annual terms (x365). You can see that the ETH-USDT liquidity pool brought its suppliers 0.093% per day.
The following illustration is liquidity pools that maximum daily ROI can sort them:
How to become a liquidity pool provider?
1) Add an equal amount of both currencies to the pool (this is done automatically). That is, if NMX is deposited for the pool of the NMX / USDT pair. The system will automatically calculate the required amount of USDT so that, for example, 1000 NMX and the same amount of USDT for a total amount of $ 2,000 are in the pool. And vice versa. That is, you need to have exactly 2 coins.
2) By sending coins to the pool, the supplier receives the pool tokens (LP tokens). Their number is proportional to the provided part of liquidity. For example, for 2000 $ deposited, you can get 200 NMX-LP or 20 NMX-lp. This will depend on the original algorithm. But less doesn’t mean cheaper or worse. This is just a guarantee.
3) When making any transaction on a decentralized exchange, a commission of 0.3% charged for the exchange of ETH / token, for example NMX, and 0.6% if the token / token, for example NMX, changed to USDT, the amount of the commission distributed by the pool between the participants according to their share.
4) In order to return their funds along with the received earnings from the pool to their wallet. The liquidity provider needs to burn their LP pool tokens. It’s very easy to do this, usually in the same place where you put them.
DeFi platforms are now looking for innovative ways to increase liquidity pools. Because larger liquidity pools significantly reduce slippage and improve the trading experience of their users. Protocols like Balancer reward liquidity providers with additional tokens to provide liquidity to specific pools. This process is liquidity mining.
The introduction of liquidity pools into Decentralized Finance (DeFi) is a big plus as it eliminates the problem of traders having to wait for market makers before they can trade. Liquidity pools and AMMs are fairly straightforward and are an improvement on the centralized order book method used in traditional finance. There are many pools of liquidity that decentralized exchanges can choose from to make trading easier, faster, and better for their users.
Why are liquidity pools good?
- Guaranteed liquidity at any price level: as described above, the liquidity pool is based on an automatic AMM mechanism. This means that traders do not need to be directly compared with each other. So as long as investors invest in the pool, its liquidity remains more or less constant. Adding it to the pool just affects the price of the coin.
- Availability and ease of earning: anyone can become a liquidity provider, which means they can start earning too. Liquidity pools do not require listing fees, KYC, or other barriers popular with centralized exchanges. Anyone can invest in an existing liquidity pool or create a new trading pair for any token at any time. When an investor wants to provide liquidity to a pool, he deposits the equivalent value of both assets. To provide $ 100 of liquidity to the USDT / NMX pool, a deposit of 100 USDT and 100 NMX required, i.e. only $ 200. In return, the investor receives liquidity pool tokens. Which represent his proportional share in the pool and allow them to withdraw this share at any time. Each time someone places a trade, trading commissions deducted from the asset that the trader sends to the exchange contract and added to the liquidity pool after the trade. For example, Uniswap charges a trading fee of 0.3%. If your contribution of 100 USDT / NMX is 0.007% of the pool, you will receive 0.007% of that 0.3% trading commission.
- Lower Gas Fees: Decentralized exchanges such as Uniswap have a minimal smart contract design that can reduce gas costs. For example, most smart contracts can only send sold funds back to the same wallet; Uniswap allows traders to exchange assets and send them to another wallet in a single transaction.
Obviously, liquidity pools play an important role in the DeFi ecosystem. Because it is thanks to them that DeFi has been able to become so decentralized.
- Liquidity is the property of assets sold quickly and at a price close to the market.
- Money is the most liquid asset that you can exchange it for anything almost at any time. Items are a low-liquid asset, are subject to a decrease in price, and also sold for a long time.
- The problem of liquidity appears in small tokens – it is problematic to buy and sell them, especially in large volumes (they are simply not available on exchanges). On ordinary exchanges, market makers who are ready to buy out any asset from you,can solve the problem, but this does not work in decentralized finance.
- This solved with the help of liquidity pools – storages in which market participants invest their tokens in order to together provide a large supply of liquidity for everyone who wants to exchange this asset. Funds blocked in the account of a special smart contract. These funds used by decentralized exchanges for trading.
- The pool allows participants to earn on commissions of 0.3% of the transaction, which are charged each time the exchange accesses the pool.
Nominex is a new name with great potential. Looking for a great cryptocurrency exchange for trading and training, look no further. We are here to provide them both with the highest quality. It founded in 2019 with just one Agenda;’ trading can be fun too.”