Liquidity pools, often referred to as just “pools” are a unique concept in the crypto market aiding the trade of currencies. Pools are most often used when handling wallets and exchanging a currency for another. The concept of a pool is simple, people who hold crypto can earn rewards and help make it easier for other people to trade crypto thus bringing more investors into the market by enticing them with reliable trading. It benefits both the pooler and the investor in the transaction.
But how do pools work? Exactly like the word implies, a pool of tokens. In this case, the pool contains equal amounts of two tokens or coins. Say for example an individual owns 10 Bitcoin and 10 Ethereum. They can go to a Swap exchange (some popular options are SushiSwap, Pancake Swap, and Uniswap) and place their funds in the pool, and in return, they will receive 10 BTC-ETH LP tokens (LP standing for Liquidity Provider) that represent their share of the pool. When an investor is looking to swap Bitcoin for Ethereum or vice versa, they can head over to an exchange that provides that option and easily trade using the provider’s tokens. A small fee is incurred and is distributed in proportion to the liquidity providers to reward them for virtually loaning their crypto to the market.
What makes crypto pools different from an exchange like Coinbase or Binance in crypto, or the NYSE in the stock market? Effectively Coinbase, Binance, and the NYSE are centralized companies that follow the order book model where they pair sellers with buyers. Swap Exchanges are decentralized and you own a part of that by supplying your own tokens and coins directly to the market for other people to trade without going through a company. This allows investors to have the best available price for the asset instead of at a slightly higher price than order book exchanges like Coinbase offer.
What are the cons? As with any investment, there is always risk. With liquidity pools, when you supply your assets you usually lock them up for 30 days or more and can’t sell off if the asset suddenly drops. Occasionally a hack happens and funds can be permanently lost. And sometimes a software glitch causes you to lose your reward fee for pooling.
Most of the time this doesn’t happen, but investors must always weigh the risk. Overall, if you are confident in an asset and already hold it, staking and pooling provide stability to you because you earn more of that asset while you hold it for the long term, think of it like earning dividends on a stock while also getting the benefits of stocks appreciation.