Shared pools, also known as liquidity pools, are an essential component of decentralized finance (DeFi) and allow for automated market making on cryptocurrency exchanges. By understanding how these pools work, crypto traders can better utilize them for swapping tokens and providing liquidity.
A shared pool contains reserves of two or more tokenized assets, locked in a smart contract. For example, a pool could contain ETH and USDC. The amounts of each asset deposited reflect the current market price between the assets. If ETH is worth $1000 and USDC remains $1, the pool would need to contain 1000 ETH and 1,000,000 USDC.
Traders can use these pools through liquidity protocols. To swap ETH for USDC, they would take some USDC out of the reserves and put in ETH at the same value. This maintains the relative 50/50 ratio of assets in the pool.
Smart contracts automatically rebalance shared pools when trades occur. If repeated trades shift the ratios, arbitrage traders are incentivized to deposit or remove funds to realign prices. This mechanism aims to keep assets priced correctly relative to each other.
Liquidity providers deposit an equal value of both assets into a shared pool. By contributing funds into the pools, they facilitate trading by ensuring enough reserves exist to fulfill demand.
When providing liquidity, LPs receive pool tokens representing their share of the total reserves. As more trades occur, transaction fees are distributed proportionally to all LP token holders. Thus over time, liquidity providers earn trading fees for supporting the pools.
The liquidity provided also creates opportunities for arbitrage trading. If big trades shift the asset ratios, arbitrageurs can profit off the divergence by realigning the pool back to the market rate.
Risks of Supplying to Pools
Liquidity providers assume two main risks: impermanent loss and smart contract risks.
Impermanent loss occurs when the market price of the assets diverges from the deposited ratio. As more trades occur at the new prices, LPs end up with less value than if they simply held the assets. This loss is only realized when funds are withdrawn.
If either asset’s value drops significantly, liquidity providers could realize large losses compared to just holding the original assets directly. Smart contracts that have not been thoroughly audited also pose risks of bugs and exploits.
Shared liquidity pools allow decentralized exchanges to automate market making. Instead of traditional order books with buyers and sellers, the smart contracts execute all trades programmatically using the pooled reserves.
Without shared pools, traders would need to find counterparties to directly exchange assets in atomic swaps. This is much less efficient and liquid compared to the automated dex model.
These pools ultimately facilitate trading of a growing number of tokenized assets on blockchains. With the rise of DeFi, shared liquidity is crucial infrastructure for crypto investors and traders.
Some of the largest shared pools support popular decentralized exchanges like Uniswap, Curve Finance, Balancer, Bancor, and Kyber Network.
For example, Uniswap V2 operates numerous pools for ETH, stablecoins, governance tokens, and more. Uniswap V3 represents the next evolution, with concentrated liquidity at specified price ranges.
Curve implements shared pools for stablecoin swaps like USDT/USDC. With low risk of impermanent loss due to minimal volatility, Curve incentivizes greater liquidity for stablecoin trading.
As DeFi expands, shared pools allow new assets to become more liquid. By understanding the risks and rewards, cryptocurrency users can better utilize these pools to efficiently swap tokens.