What are Liquidity Pools?
Decentralized exchanges improve efficiency by replacing the middleman (Centralized exchanges like Coinbase, Binance) with the help of automated smart contracts.
One such exchange is Uniswap which utilizes an innovative mechanism (Automated Market Making) to automate trades. This also allows any user to provide liquidity into the pool and earn a share of the exchange fees. Fees are distributed to all participants of the pool and no centralized entity receives any profits.
✅ Non-custodial Trading allows for true ownership of assets without handing your private keys and ownership of your digital assets over to centralized entities
✅ Permissionless Instant Settlement as trades can be settled through smart contracts without KYC or depending on centralized exchanges
✅ Liquidity Pooling allows anyone to provide liquidity into the pool in equal portions to earn exchange fees on their digital assets
❌ Slippage with Larger Quantity Trades as users receive price quotes based on the token quantity desired and the liquidity available in the pool. This could cause significant slippage on larger sized trades.
❌ Liquidity Providers lose control of the ratio provided into the Liquidity Pool (For example, a user who deposited 50% ETH and 50% DAI could end up with 75% DAI and 25% ETH on withdrawal, limiting upside if prices of ETH had went up)
Liquidity providers provide equal values of both pairs in the pool to earn exchange fees from traders who use the pools to swap tokens. This essentially creates a synthetic position that benefits liquidity pool providers most when they expect a narrow trading range during the duration of the liquidity provision. This is similar to a short straddle position in option markets.
Liquidity Pools are thus most beneficial to specific trading pairs that:
👍 Expected to maintain at a 1:1 exchange rate in the long run
👍 Users value either pair equally and are agnostic to holding either of the pair
👍 Can generate yield while sitting in the liquidity pool
Yield Enhancing Liquidity Pools thus combine the best features of all the above into a product ideal for generating yield on Stable trading pairs or any asset with a expected 1:1 value in the long run.