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🏊🏻‍♂️ Dive in the Pool # 1 : The Liquidity Pools

Published on 
December 29, 2023

Are you curious about cryptocurrencies and decentralized finance (DeFi)? Well, you’re at the right place!

Welcome to the first episode of “Dive in the Pool” where each week the Lobster’s team help you understand DeFi!

In today’s episode, we’re gonna go into…well…the liquidity pools!

Ready? Let’s dive in!

Do you have cryptocurrencies lying dormant in your wallet? Are you looking for a way to mobilize them to generate additional income?

This article will help you understand the basics of decentralized finance (DeFi) and reveal how to unlock new investment opportunities.

🚰 Liquidity pools: No intermediaries, more opportunities

In traditional finance, an algorithm is used to match sellers and buyers. It is called an order book. If you ever have traded on a centralized exchange (CEX) like Binance, you surely have seen it. It looks like this. By providing this service, the platform takes a commission on every transaction.

Order Book From Binance

In the world of decentralized finance (DeFi), we don’t need intermediaries. To enable users to exchange their cryptocurrencies, we use what is known as liquidity pools. Let’s take an in-depth look, shall we?

💧 What are liquidity pools?

Liquidity pools are reservoirs of funds which are automatic programs, known as smart contracts, where individuals or organizations with cryptocurrencies, known as liquidity providers (LPs), deposit their funds.

The action of depositing funds in those pools is called liquidity providing. By doing so, they’re not just parking their funds; they’re actively fueling the ecosystem. These deposits enable many types of transactions on decentralized exchanges (DEXs) like Uniswap, ranging from simple token swaps to more complex financial operations.

In return, the LPs receive shares of the transaction fees generated by the pool, ranging from 0.3% to 1%, in proportion to their contribution.

That’s not all, they also receive LP tokens that act as receipts, letting them take back their funds whenever they wish. These tokens, besides being exchangeable for your share in the pool, can also be used in other DeFi applications.

Liquidity pools work autonomously. To determine the price of an asset in the pool, DeFi protocols use algorithms called Automated Market Makers (AMMs).

🤖 The role of AMMs (Automated Market Makers)

AMMs determine the price of assets in a liquidity pool based on the quantity of assets available in that pool. How they work would merit a full article, which we won’t go into now.

Generally speaking, a pool contains two cryptocurrencies, often in a 50/50 ratio. Other configurations exist, but are less widespread. In this episode, we’ll look at how Uniswap V2 pools work. To make you a true DeFi expert, let’s take a concrete example!

📝 Practical example:

In this example, let’s say 1 ether (ETH) = 1000 USDC ($1000).

You have some ether (ETH) and USDC. You decide to place them in an ETH/USDC liquidity pool on Uniswap following a 50/50 ratio. For example, 1 ETH and 1000 USDC.

The pool contains a total of 500 ETH worth $500,000 and 500,000 USDC, also worth $500,000. In exchange, you receive LP Tokens, which serve as proof of your contribution.

Congrats! You are now a liquidity provider! But what’s next?

🔄 How does a trade work ?

When a trader exchanges, say, 0.5 ETH in exchange of 500 USDC in the pool, the quantity of ETH increases while the USDC decreases, the AMM automatically adjusts the price of ETH according to supply and demand, causing its price to decrease. We all know that trading involves risks, but providing liquidity is no exception!

How does a trade work - Practical Example

😨 The Impermanent Loss: The fear of every liquidity provider

The risk for liquidity providers is called “impermanent loss.” It comes into effect when the price of assets deposited in a liquidity pool changes after they have been deposited, creating a difference in value compared with when they were held outside the pool. The risk of impermanent loss also deserves a full article. In the meantime, let’s take a look at how Uniswap V3 is transforming this dynamic with its innovative approach to liquidity.

🦄 Uniswap V3: Efficient use of liquidity

Since its launch in 2018, Uniswap has constantly innovated in the DeFi field. Whereas Uniswap V2 distributed liquidity evenly across an asset’s price range, Uniswap V3 has introduced a revolutionary concept: concentrated liquidity.

This model enables LPs to target specific price ranges for their assets, and generate higher returns than with V2 pools. On the other hand, if the price falls outside of the price range, you don’t generate any yield.

You can find our article explaining Uniswap V3 pools in detail here.

🦞 Lobster Protocol: Maximize your DeFi strategies

As you may have understood, this approach can generate higher returns, but by targeting a specific price range, it needs an almost constant monitoring and technical competences.

Let’s be real, what we all want is to generate the more yield possible without spending time managing our position. The realm of DeFi can be one of the best places to make efficient use of your funds. Unfortunately, it can be challenging if you don’t have the technical knowledge.

That’s where Lobster comes into place. Our solution is especially designed to maximize your yield without the need of constant monitoring.

By depositing a single asset into one of our vaults, you can choose an investment strategy and benefit from our continuous optimization, adapting your investment strategy to changing market conditions, reducing risk and simplifying the management of your position. We have strategies relying on liquidity providing.

Lobster is totally non-custodial, meaning you always remain in control of your funds. When you deposit your assets in one of our secure vaults, you receive a receipt token that allows you to withdraw your funds anytime, autonomously.

Unlock the full potential of liquidity providing without its complexity.

Earn more with Lobster, try it now!