I have been using Liquidity Pools on HIve for the two years that I have been a user of Hive.
The great thing about them of course is that they are Hive based which means that so many of the risks normally associated with Liquidity Pools elsewhere are minimised here!
That's fluffing Good news for us!
With the launch of the new p2e game Holozing on Hive, I have seen loads of posts from users quoting and mentioning LP without having a scoody doo what it is!
This then is a quick intro into the murky world of liquidity pools.
Fear not, have a read of this and those murky waters soon become crystal clear!
What are liquidity pools in cryptocurrency?
Within cryptocurrency, liquidity pools play a crucial role in having seamless and efficient transactions on decentralized exchanges (DEXs).
On Hive, we trade using Hive-Engine our DEX.
Liquidity pools act as a central repository of crypto assets. This lets traders exchange one token for another without the need for intermediaries like traditional centralized exchanges. Because we don't really like CEXs!
The 3 key elements of Liquidity Pools
Liquidity pools consist of three key elements:
1 - Smart Contract: This is the backbone of a liquidity pool. It functions as a self-executing code that manages the pool's operations that maintains the balance of assets. It ensures that trades are executed fairly and transparently. After all blockchains are all about transparency!
2 - Liquidity Providers (LPs): LPs are the individuals who contribute their crypto assets to the liquidity pool. They earn rewards in the form of transaction fees for providing liquidity. Part 2 of this post will look at various Liquidity Pools on Hive and how to provide liquidity to them.
3 - Trading Mechanism: The trading mechanism within a liquidity pool is automated and algorithm-driven. It keeps on matching buy and sell orders based on the pool's current asset ratio and the prevailing market conditions.
How do Liquidity Pools Work
1- Swapping Assets: When a trader initiates a swap between two tokens within a liquidity pool, the smart contract automatically executes the trade using the available assets. The algorithm then adjusts the pool's balance to reflect the new trade.
2- Reward Distribution: LPs receive a share of the transaction fees generated by trades within the pool. These fees are the primary reward for providing liquidity.
Pros of Liquidity Pools
Everything has Pros and Cons!
1- Decentralization: Liquidity pools remove the need for intermediaries like traditional exchanges, thus making it a more decentralized and transparent trading environment.
2- Reduced Fees: Since DEXs don't charge additional fees for managing liquidity, we benefit from lower trading costs compared to centralized exchanges.
3- Enhanced Security: Liquidity pools are secured by blockchain technology, ensuring the integrity and immutability of transactions.
Cons of Liquidity Pools
1- Price Fluctuations: Liquidity pools are susceptible to price fluctuations during periods of high volatility, potentially affecting LPs' returns.
2- Impermanent Loss: Impermanent loss refers to the potential loss of value experienced by LPs due to price changes. It arises from the rebalancing mechanism of the pool to maintain asset ratios. Most people have no clue about Impermanent losses and this really is a danger to the novice.
3- Smart Contract Risks: Smart contracts, while secure, carry a certain degree of inherent risks. The good thing is on Hive this is very low risk.
The bottom line is that liquidity pools are a great way to receive passive income from DeFi!
In general the ratio of each asset in the liquidity pool trading pair will be 50:50 (in USD terms)
What does the APR of a liquidity pool mean?
When talking about liquidity pools, APR (Annual Percentage Rate) is the estimated annual return earned by liquidity providers (LPs) for contributing their crypto assets to the pool. It represents the total percentage of rewards that LPs can expect to earn over a year, assuming the current trading volume and fees remain constant.
APR is calculated by taking the total amount of fees generated by the liquidity pool in a given period and dividing it by the total value of assets locked in the pool. This value is typically expressed as a percentage.
You should remember that APR is an estimate, and the actual returns may vary due to several factors, such as:
Trading Volume: The higher the trading volume in the pool, the higher the APR for LPs.
Price Fluctuations: Significant price changes in the underlying assets can affect the APR, potentially leading to impermanent loss for LPs.
Dynamic Rewards: Some pools may offer additional rewards or incentives, such as governance tokens or token distribution airdrops, which can further increase the overall APR.
Impermanent Loss: Liquidity providers are exposed to impermanent loss, a potential loss of value due to rebalancing of the pool's asset proportions in response to price fluctuations.
When evaluating APRs of liquidity pools, it's crucial to consider these factors and conduct thorough research before committing any funds. While high APRs can be enticing, it's essential to weigh the potential risks and ensure that the pool aligns with your investment objectives and risk tolerance.
Why does the APR of a new liquidity pool start high and then go down?
There are a few reasons why the APR of a new liquidity pool starts high and then goes down.
1. Initial Demand: When a new liquidity pool is created, there's a high demand for liquidity, as traders are eager to exchange tokens on the new exchange. This demand drives up the APR, as LPs are willing to provide liquidity in exchange for a higher return.
2. Pool Maturity: As the liquidity pool matures and the initial demand subsides, the APR slowly decreases. This is because the pool has more liquidity, so traders are less willing to pay high fees to exchange tokens.
The first two apply to Hive and help explain to the people that have asked me why Holozing's pool APR goes down daily.
For people that use other chains then ...
**3. ** Increasing Competition: As more liquidity pools are created for the same tokens, the competition for LPs increases. This drives down the APR, as LPs have more options for where to stake their tokens.
**4. ** Protocol Fees: Some protocols charge a fee to LPs, which can also reduce the APR. This fee is typically used to support the protocol's development and maintenance.
**5. ** Arbitrage: Traders may arbitrage between pools to take advantage of differences in APRs. This can further reduce the APR over time.
It is important to note that the APR of a liquidity pool is not guaranteed, and it can fluctuate significantly. You should carefully consider the risks involved before providing liquidity to a pool.
Above all Do Your Own Research.
Part 2 will show where to add liquidity on Hive.
Thanks for visiting and enjoy the rest of your day!
All images and ramblings are from me, the mad Scotsman TengoLoTodo unless identified in the post text.
