Understanding Liquidity Pools on Decentralized Exchanges

Crypto Rookies
6 min readMay 5, 2023

Crypto investors, and web3 entrepreneurs should develop a deeper understanding of liquidity pools on decentralized exchanges (DEX) to maximize their success.

Decentralized Exchanges

Exchanges are meant to match buyers and sellers for any products or assets to be exchanged. In the case of currencies, the exchange is the middleman between the two parties. Usually, the exchange takes the risk of buying Singapore currencies for example at a specific rate, expecting they can sell the Singapore currency back to a buyer in the future at a higher price than the exchange paid. This way the exchange can operate profitably while providing the service to buyers and sellers in a way that ensures buyers and sellers do not have to wait for their counterpart to perform the transaction. This makes the exchange more liquid and efficient for participants.

A decentralized crypto exchange accomplishes the same thing but without any human intervention through the use of smart contracts (blockchain technologies). The price of various currencies, or tokens in this case is usually assessed by a bounding curve formula which is X times Y = K, where X and Y are the quantities of token X and Y that are currently locked as a pair into a smart contract that in this case is called a Liquidity Pool. This enables participants to swap back and forth between the two pairs. Meanwhile, K is the constant and comes from the original injection of token X versus Y during the creation of the liquidity pool. Let’s take an example where Ethereum, a popular crypto-currency, is paired with USDT, a stablecoin that represents $1 of US currency. At the time of this writing, Ethereum is worth roughly USD $2000, which means the ratio of X = Ethereum, versus Y = USDT in the liquidity pool would be 2000 USDT for 1 Ethereum and assuming for simplicity that there is only 1 ETH and 2000 USDT in the creation of the liquidity pool then K = 2000 = 2000 ETH * 1 USDT. The bounding curve is now active and K has to remain constant when X or Y changes when participants swap between either pair of tokens. For example, if someone wants to buy ETH with $100 worth of USDT, then K has to remain constant and X = K / (Y+100) => X = 2000 / (2000 + 100) => X ~ 0.95. This implies the new price of Ethereum in the pool is now 2100/0.95 = $2,210.50. As you can see, the smaller the amount of liquidity in the pool, the more volatile the price is, this is called slippage.

More importantly, the prices can never reach zero in either direction, as the cost become exponentially higher and it follow the behavior of the curve in Figure 1.

Figure 1. Bounding Curve on Uniswap

In order to reduce volatility, web3 entrepreneurs need to inject more tokens of both pairs in the pool at the creation so that potential investors can swap without excessive volatility. Unfortunately, scams in the crypto industry are common, and sometimes projects enjoy having really small liquidity pools in order for the token price to appreciate very rapidly as demand increases, which creates a fear of missing out (FOMO) behavior.

Figure 2. Uniswap Liquidity Pool

Risk of Bank Run

Liquidity Pools on DEX will never have a true bank run like it recently happened to many US banks such as Silicon Valley Bank, Signature Bank, etc. However, this means investors that are last selling tokens would only get a very small fraction of their initial investments in comparison to the US dollar. This should be easy to understand, but too often people assume that because the price of the token is $5,000 and that they bought at $2,000 that they now have gained significant value, however imagine the scenario above where if we assume that the liquidity pool is composed of only 1% of the circulating supply of Ethereum. This means that if an investor buys 0.05 Eth for $100 USDT, the value “created” for everyone that owns ETH is now $210.50 / 0.01 = $21,050 of value created for only $100 added in the liquidity pool. So, if another investor sell 1 ETH they own, because there are 99 ETH in circulation in the hands of investors, while there was only 1 ETH in the liquidity pool, that means now the liquidity pool will go from 0.95 ETH to 1.95 ETH, and since K remains constant, then Y = USDT = 2000 / 1.95 = 1025. So, the investor only received $2100 — $1025 = $1075 for that 1 ETH instead of $2100, and now the value of all other investors has reduced by $102,500 for that $1025 withdrawal… So, not a bank run, but it may as well be. The actual value of your tokens may not be as much as you think.

Yield Farming

Yield farming is the process of collecting transaction fees for contributing liquidity pairs into liquidity pools. For example, anyone can add ETH/USDT pairs on Uniswap and collect transaction fees when other participants swap between the two tokens. The fees collected will be based on the volume of transactions versus the total value locked into the pool. Some pools can generate 200% return per year, while others may provide only 5% per year. So, any potential yield farmer should do the proper calculations before committing some of their capital. It can be a great way to earn passive income on your capital while the market is moving sideways, however there are dangers to be aware of when the market is trending up or down significantly.

Impermanent Loss

Impermanent loss occurs when one token in a liquidity pair grows or decreases significantly. In the example above, when the price of ETH went from $2,210.50 down to $1,075, this means whoever had locked the original liquidity pair of 1 ETH and 2000 USDT, they have actually now received 1.95 ETH and 1025 USDT, and that means their total capital value has shrunk from $4000 (1 ETH + 2000 USDT) down to 1.95 * 1075 (ETH) + 1025 (SUDT) = $3121.25. So, they have lost money at that point in time, but if the price of ETH goes back up, then the loss is not actually real unless they cash out their capital, which is why it is called an impermanent loss.

Liquidity Pool with Active Range

To protect liquidity providers from impermanent loss, Uniswap newer versions now offer a range where your liquidities are active. This can come handy for yield farmers, but also for web3 entrepreneurs.

Figure 3. Liquidity Pool with Active Range

Conclusion

I would urge web3 founders to create liquidity pools for their project that are large enough to prevent excessive volatility since while it may be fun to see the price grow rapidly, it will come back to hurt you and destroy the confidence of your users.

Meanwhile, investors should be worried about tokens prices that grow excessively fast, if you don’t sell at the top, you can expect the value of your assets to be wiped out at any moment there is a reversal. We call this a pump and dump scenario which is my life’s work to avoid.

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