What Are Liquidity Pools?

You know how frustrating it gets when you end trades, only to get a sudden reversal a few seconds later?

Well, you're not alone! Anyone with some form of trading experience knows how it feels to suddenly witness your predicted outcome come true the minute after you've exited a trade.  Many traders set stop losses, not knowing that they're about to hit their points. Most beginners tend to set them too close, or too far to avoid missing out.

The big investors often use these stops by building on them early on. In other words, the larger players treat these stop losses as an insight into the future of the market.  As it stands, getting 100% wins in any cryptocurrency is almost impossible. There will always be losses in the market, and all we can do is try to avoid them as much as we can. Once you're able to get a sense of when and why the market has specific reactions, you become a better trader. This starts with an in-depth understanding of liquidity pools.

Have you ever heard of liquidity pools? Do you know how they work? Why are they so important when dealing with decentralized finance? We'll learn more about this as we go on.

Liquidity Pools

Liquidity pools are pools of tokens kept in smart contracts and used to implement trading. You should think of them as levels and instances in which asset prices often "decide." We're talking about the exact points or levels where the market makes a decision based on the money flow directed to it. Most of the time, we refer to them as the intersections of orders. These pools, like DeFi liquidity mining, are extremely useful when users try to manage open trading, tweak their stop losses, and initiate new orders.

How Does a Liquidity Pool Work?

All you need to know for now is that "the pool" operates by eliminating the total dependency of coins on trade volume. The best way to learn how to use liquidity pools is by taking a look at liquidity pool exchanges. Let's look at Uniswap and Bancor.

Uniswap

Uniswap is a popular ETH & ERC 20 token exchange that uses the decentralized network. It is known basically for its 0.3% trade charge fee attached to all liquidity pools. Since we haven't had a pool in the form of token-token pools, Uniswap uses the token-token trading fee options in two steps. First, the user would have to resell the sold token for an equivalent amount of ETH. Then they would have to make another sell order on the ETH token pool to purchase the desired tokens.

Bancor

Just like Uniswap, this liquidity pool provider works effectively within the BNT, EOS, and ETH token ranges. Additionally, Bancor has recently been approved to support trade tokens like USDB and other ETH family tokens. Aside from its pool, its transactions with Ethereum are one of the top reasons people look into a liquidity pool. Bancor has flexible trading fees, which allow first users to include liquidity pool on Relay. Currently, these fees range between 0.1 and 0.5%.

Different Types Of Liquidity Pools

Uniswap and Bancor are two of the very basic forms of available providers. Over time, there have been several projects built and developed on this concept known as "crypto loans without collateral," and they came up with innovative ideas.

Let's take Curve as a first case study. Curve pool liquidity helps traders and experts realize how flawed Uniswap's so-called 'automated mechanism' is with their assets. It barely functions with assets having similarities with its new price. Assets like wETH, sETH, and stablecoins often prove very difficult to analyze with Uniswap. By simply taking a different algorithm approach on curve pools, we could get lower fees during token conversions and exchange.

Balancer or Dao is another among the famous liquidity providers. Dao helps users understand that they don't always have to restrict themselves to owning a maximum of two assets per pool. Though this has idea has been around for the longest time, with Balancer, users can explore as many as eight tokens per liquidity pool. This is one type of liquidity pool you should take advantage of today.

Why We Need Liquidity Pools

We need to provide financial liquidity across decentralized exchanges. Anyone familiar with globally accepted crypto exchange platforms like Binance and Coinbase can tell the trading fees and techniques they operate on. They use the order book model most frequently, just like stock exchanges such as Nasdaq and NYSE. To put it simply, the order book reveals the buyer-seller sync when placing orders. Typically, this is where one is bidding at a lower price and selling for the highest possible.

For a transaction to happen in the market, both participants have to converge at a specific price. But what happens when both parties aren't willing to come to reasonable terms? What if there's one coin shortage of a particular asset to be bought? At this point, the "Big Boys" or market players step in.

When these market makers place these large-scale buy or sell orders, they create revenue for liquidity providers. When this happens, 'smaller' users now have access to active trades without having to wait for vague counters in the market.

Pool tokens are necessary because the order book model only relies on significant decisions made by multiple market makers. With the order book model, it's these makers who have to trigger these moves in order for us to see the right outcome.

Slight changes in these prices result in multiple orders sent to an exchange. ETH, for example, with its process of having multiple transactions per second and 10-19 seconds of block time, isn't made for any order book exchange.

There are some promising ones like Loopring. Unfortunately, they still subscribe to market makers' decisions. To add to that, there have numerous reports of the website being prone to issues. And if that wasn't enough, users have to follow additional steps on every trade as these funds have to be transferred from the second layer and back. With these setbacks, it's clear that the markets need for a new invention in the decentralized world.

The Value Of Liquidity Pools

Liquidity pools ensure constant and stable liquidity among trades of various volume and asset types. Here are the benefits of liquidity pools compared to the outdated order book protocol:

  1. One of the advantages of using liquidity pools is that you can expect liquidity at all price levels. As long as you've got your investment in the form of deposited assets, the pool guarantees stability. You don't have to wait to be manually paired with traders to get your orders into the market.
  2. The biggest importance of liquidity pools is lower gas fees. Uniswap and other major decentralized exchange platforms have cost-effective smart contracts designed for gas price reduction. When we have minimal prices and charges of exchange or distribution within the pool, it means useful friction and more liquidity in transactions.
  3. Guarantees Passive Market Pricing. Unlike with book exchanges where there's a constant need for the adjustments of bidding and asking prices by market makers, pools offer a more passive option. A low liquidity pool isn't restricted to limited information from multiple exchanges to analyze the prices of assets. With the smart contract option, you get trading tips daily and passive pricing in real-time to know the amount of good or bad liquidity pools for you.

Conclusion

Liquidity pools help and keep you from being exploited by stop losses and high trading fees. Many have lost and jumped out of a potential profit trade due to wrong stop losses positioning. With the right knowledge, you can hop off the train of constant losses and maximize liquidity.

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