LIQUIDITY POOL
Funds are added to liquidity pools by liquidity providers (LPs). A liquidity pool might be compared to a sizable sum of money that traders can trade against. LPs receive fees from trades that take place in their pool in exchange for supplying liquidity to the protocol. In the case of Uniswap, LPs contribute to the ETH/DAI pool an amount equal to the value of two tokens, for instance, 50% ETH and 50% DAI.
Wait, anyone can work as a market maker? Indeed! Adding money to a liquidity pool is simple. The protocol establishes the incentives. For instance, Uniswap v2 charges traders 0.3%, with the money going straight to the LPs. In order to draw more liquidity providers to their pool, other platforms or forks may demand lower fees.
Why is it crucial to draw in liquidity? Because of the way AMMs operate, large orders may experience less slippage the more liquidity there is in the pool. More volume may then be drawn to the platform as a result, and so forth.
Different AMM designs will result in different slippage problems, but it is unquestionably something to be aware of. Recall that an algorithm determines pricing. To put it simply, it is based on how much the ratio of the tokens in the liquidity pool changes following a trade. There will be a lot of slippage if the ratio fluctuates by a significant margin.
Let's take this a step further and assume that you wanted to purchase every single ETH in the ETH/DAI pool on Uniswap. You couldn't, though! You would never be able to buy all of the ether from the pool without paying an exponentially larger premium with each new unit. Why? It results from the equation x * y = k. The equation is no longer valid if either x or y is zero, which indicates that there is no ETH or DAI in the pool.
However, this does not tell the whole tale of AMMs and liquidity pools. When supplying liquidity to AMMs, you need also be aware of impermanent loss.
We will stop here for now. Next time we will talk about impermanent loss to further understand what it's all about. Thank you!
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