Liquidity pools

Replacing the order book

On a traditional exchange, buyers and sellers post orders and get matched. Most DEXsDecentralized exchange A smart-contract-based marketplace where people trade tokens directly from their own wallets. instead use an automated market makerAutomated market maker A DEX design that prices trades using a formula and a pool of tokens instead of an order book.: a smart contract holding two tokens in a liquidity poolLiquidity pool A pot of two or more tokens locked in a smart contract that traders swap against. and a formula that sets the price based on the ratio between them.

When you buy token A with token B, you add B to the pool and remove A. A becomes scarcer in the pool, so its price rises slightly. Bigger trades move the price more. That’s slippageSlippage The difference between the price you expected and the price your trade actually got..

Liquidity providers

Anyone can deposit both tokens into the pool and become a liquidity provider (LP). In return, LPs earn a share of every trade’s fee.

The catch: impermanent loss

If the prices of the two tokens move apart, arbitrage traders rebalance the pool, and LPs end up with more of the token that fell and less of the one that rose. Compared with simply holding, that’s impermanent lossImpermanent loss The shortfall liquidity providers can face versus simply holding, when the prices of pooled tokens move apart.. Fees can make up for it, but not always.

Questions to ask before providing liquidity

• Are the fees likely to exceed impermanent loss for this pair?
• Has the contract been audited, and how long has it run safely?
• Are the tokens themselves legitimate, and is the pool deep enough?