What is a Liquidity Pool in Crypto? (Animated) - العناوين المزدوجة
In this video,
we are going to cover liquidity pools,
using stories, examples, and analogies so that the concept is broken down so much that your grandpa could understand it.
At that's what we keep saying.
If you don't know what liquidity pools are, you should be excited to learn about them.
Basically, liquidity pools are not imaginary pools filled with water, but they are pools filled with money.
In fact, They are actually smart contracts that allow traders to trade tokens and coins even if there are no buyers and sellers out there.
First, let me explain how the traditional stock market works.
It uses what is called an order book model.
This means all the buyers and sellers write down and then they submit their orders for
how much of a stock they want to buy and at what price they want to buy it.
Whenever two buyers and sellers meet at the same price, a trade is transacted.
The buyer gets the stock and the seller gets the cash.
For example, an order book might look like this.
See if you look here,
where someone is asking to buy 16 stocks at $13.45 and over here where someone is asking to sell 20 stocks for $13.
dollars and 80 cents.
Essentially, when you want to buy a stock on Robinhood for example, and at what we call market price, you are essentially just submitting an order to buy
all of the stocks that you want to, at the current price at which sellers are willing to sell it for.
If you look at this graph, the left one, you can see how many buyers and sellers there are at different prices.
Now, you need to know, this is very inefficient if you want to buy or sell, because you have to set a price that someone
else is willing to buy or sell at.
At least if you want to buy or sell your stock immediately,
otherwise you have to wait around and hope that eventually the price matches what you're looking for.
Well, so what's the solution?
It's a liquidity pool that uses an algorithm.
With this algorithm,
we will always be able to buy or sell an asset no matter how high or low the price is and no matter what time
of the day it is and no matter if there is a buyer or seller to meet our current needs.
A pool is a pool of money that contains both assets of what you are wanting to trade for.
For this example, we going to be using Ethereum and Basic Attention Token.
Now, before we continue, We highly recommend watching our videos on smart contracts because they are the technology that allows a liquidity pool to exist.
A pool is nothing more than just code.
It is a smart contract written in a way to hold certain funds,
do math with those funds, and then allow you to trade based on the math that it did.
So let's get a little technical.
starts off with an exact ratio of 5050.
This means if you wanted to give the pool $500 so that it could trade,
you must give it $250 of Ethereum and $250 of basic attention token.
Why?
Well, you'll see in a minute.
Most liquidity pools use an algorithm called a constant product automated market maker,
which is a bunch of large words that if you have no idea what they mean we highly recommend you to watch our video on it.
We recently just posted a video that basically breaks down the math using examples and the algorithm using an analogy.
We think it'd be super helpful for you to understand this topic.
Anyways, as you buy more and more basic attention token by giving it Ethereum, it will slowly raise the price that you are paying.
for each token.
For the first one might be $1.20.
The one you buy after that might be $1.20 and a tenth of a penny.
The next one that you buy might be $1.20 and $3.10 of a penny.
And after you've bought a hundred basic attention token, the price might be $1.50.
So that might have been confusing, but think about it like this.
As you buy more and more basic attention token.
the liquidity pool will charge you more and more for each one.
Now is because it wants to keep the perfect 5050 ratio of Ethereum and basic attention token.
Well, you're buying more basic attention token and you're giving it Ethereum,
so that it thinks the price of Ethereum is dropping because there's a lot more of it in the pool.
And so for it to keep the 5050 value ratio,
it will essentially essentially, raise the price of basic attention token, at least using the algorithm that it uses.
If made it this far without watching our automated market maker video, congratulations.
But if you're still confused or you didn't get any of that, go watch the AMM video and most of this will make perfect sense.
Now, something to keep in mind with liquidity pools is that every transaction has a attacks.
It cost a very small percentage of each trade for you to make a trade,
and we'll go over where that money goes in a minute.
A example of a liquidity pool is Uniswap.
They allow you to trade almost any Ethereum token for any other Ethereum token, and the cost is a very small fee.
Moving on, one important and powerful thing of liquidity.
The liquidity that I want to mention is that what if we have a bunch of basic attention
token and instead of trading it for Ethereum, we want to trade it for some of the graph token.
Well, most decentralized exchanges will hook up two liquidity pools together to allow you to perform that trade directly.
For example, you tell it that you have basic attention token and want to buy the graph token.
Well, that decentralized exchange will actually do two swaps.
The first one,
it will do basic attention token to Ethereum,
and then it will do Ethereum to the graph token, essentially swapping out basic attention token for the graph token for you.
Now the technical term for this is routing, and it's very powerful.
The decentralized exchange will route some trades for you.
so that you can essentially trade any token on their platform for any other token,
even if there aren't a bunch of liquidity pools for that token.
So now that we know roughly how a liquidity pool works,
let's go over why you would want to put money into one, because you can be an investor in a liquidity pool.
And when you do this, whenever you put money into a liquidity pool, you are what is called a liquidity pool.
provider.
So do you remember how I said every trade takes a very small, small fee?
Well, as more and more people trade, those fees start to add up.
Where do those fees go?
They go to the liquidity providers.
So let's say you put in $500 of Ethereum and $500 of basic attention token into a liquidity pool.
Your friend decides to join you and he does the exact same thing.
same thing.
So now there is $2,000 total in the liquidity pool.
Now as people are trading in and out all day long, let's maybe say you rack up $150 in fees.
At the end of the day,
since you owned 50% of that pool, because friend owned the other half, you earn $75 for providing that liquidity.
And yes, these fees can add up to be substantial.
substantial amounts in the current crypto atmosphere.
Some decentralized exchanges are offering up to 500% APR, and this is because they are making a boatload of money from the fees.
And the technology is new, there aren't very many investors.
But as more and more people join the pool, your cut gets less and less, but it also makes the price more stable.
What are the funds?
The fundamental of how a liquidity pool works is that as the pool grows in liquidity,
as more money is put into it, it takes much more money to move the price of both assets.
For example,
if someone came to your $2000 liquidity pool and dropped in $500 because they wanted to trade their Ethereum for a basic attention token,
they could raise the attention token a lot because essentially they bought a ton of it up and so due to the algorithm
now there's not much in the pool but there's a ton of Ethereum and because of how the AMM algorithm
works BAT will cost more and Ethereum will be cheaper well if there was five million dollars
of liquidity in that pool and someone came along and put in the same five hundred dollars dollars,
the price would not move much,
because they would barely take any of the BAT out and they would barely give any Ethereum,
at least in proportion to how big the pool is.
So one term you need to know is price impact,
and this basically means how much can I affect the price by buying from this liquidity pool.
If the pool is small, there will be a very high price impact.
In short, you will affect the price a lot.
And in some cases, you can even double or triple the price of an asset very easily.
However, as the pool grows and it gets larger and larger, the price impact gets smaller.
And buy-ins affect the price less.
Another worth mentioning is something called arbitrage traders.
You remember how I said if someone buys it.
a bunch of basic attention token that the price of Ethereum would drop, well, at least in that pool.
Ethereum be $450 for each Ethereum in that pool after someone gave it a ton of Ethereum.
Well, what if you could sell your Ethereum to Coinbase for $500?
You could buy a bunch of Ethereum from that pool and then immediately go and sell it to Coinbase.
transaction you would make $50 off of every Ethereum that you sold.
This is called arbitrage trading.
And might be like,
why are they going to do a bunch of trades if all they're going to do is scoop up a bunch of profits?
Well, that is exactly what they're doing.
But they're also paying that very small fee.
And they're also helping to keep the pool prices the same as other exchange prices.
They are essentially- helping to keep a stable price of that token by ensuring that it's the same price everywhere.
If not,
they can buy it at a place that sells it cheap and they can sell it at a place that buys it at a higher price.
In short, they will make a profit, but we need people like that.
In fact, you could be one of those people.
One more thing about the power of liquidity pools.
They can get complicated.
very quickly.
For example, Balancer is a platform that currently allows up to eight assets in a single liquidity pool.
The and the algorithm on that is crazy, but it does show the limitless possibilities of decentralized finance.
Ending this video, you should know there are also risks involved with investing in liquidity pools.
For example, two big ones, are impermanent loss and rug pools.
Now those are both topics for another video, but you should keep them in mind when you're investing in these highly profitable liquidity pools.
If you've enjoyed this video,
please reward our hard work by clicking the thumbs up below and consider subscribing,
so that you get notified whenever we post a video about impermanent loss or rug pool,
and we promise to make the topics so simple that your grandpa could understand it.
Thank you guys so much for watching.
We hope that you learned something and we hope to see you in the next video.
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