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What is a Liquidity Pool?

April 16, 2021

What does "Pooling" mean

Traditional Finance:

  • Most exchanges maintain an order book and facilitate matches between buyers and sellers.
  • For each successful match, traders are charged exchange fees that go directly to exchange operators.

The DeFi Difference:

  • Smart contracts hold liquidity reserves of various tokens, and trades are executed directly against these reserves.
  • Prices are set automatically using the constant product market maker mechanism, which keeps overall reserves in relative equilibrium.
  • Reserves are pooled between a network of liquidity providers who supply the system with tokens and receive a proportional share of transaction fees accrued.

Adding Liquidity

In the example below a user is supplying ETH and DAI to a Uniswap pool. After adding their assets, they receive Uniswap liquidity provider tokens which represent a share of the underlying assets in the smart contract. When supplying liquidity to Uniswap, the assets need to be provided in 50/50 proportions. For example, if adding $1000 in liquidity to the ETH-DAI pool, $500 worth of DAI and $500 worth of ETH must be added.

Adding liquidity to the UniswapV2 ETH-DAI pool

Access Pools with a Single Click

Zapper allows you to add liquidity in a single transaction. For example, if you only have ETH but would like to supply to the ETH-DAI Uniswap pair with Zapper, you don't have to worry about manually converting half the ETH into DAI and then submitting another transaction to add the liquidity.

Part 1: Zapper contract swaps 50% supplied for the other pool token

Instead, Zapper contracts will handle this under the hood and swap to exactly half the amount of ETH into DAI and will then add both assets to the Uniswap pool. Lastly, the contract will pass the liquidity provider tokens back to your address at the end of the transaction, both steps are completed in one transaction.

Part 2: Both assets are supplied and the LP tokens are forwarded to the user's address

Impermanent Loss

Impermanent loss sounds like a scary term, but can be broken down into a simple balance between the amount of fees collected by a pool vs the amount of price shift between the supplied assets. Pairs that earn large amounts of fees tend to be the ones that have the most price divergence between the underlying assets.

Uniswap LP Tokens are like a 50/50 index

In simple terms, when supplying liquidity it is easiest to think that when entering a pool that the liquidity provider tokens are a weighted index of the pool you are in. So when you add ETH to the ETH-DAI Uniswap pool they now hold an LP token that is somewhat like a 50/50 weighted index between ETH and DAI. This pool tends to earn lots of fees due to people frequently trading between the assets. However, as a liquidity provider, you no longer have full-price exposure to ETH.

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