Liquidity Pools
- Liquidity Pools allow users to stake their tokens and earn rewards in the form of LP tokens
- Liquidity Pools act as a market maker mechanism by providing liquidity for the trading of two assets
- Flare Finance offers Liquidity Pool staking in order to facilitate their FlareX product
- One of the risks of Liquidity Pools is called Impermanent Loss
One of the first concepts you hear about often in DeFi is Liquidity Pools. It is a fairly straightforward concept and we will go into what Liquidity Pools are and how to earn from participating in one.
Liquid Pools can serve as another form of income generation for token holders, but what other purpose do they serve? Whenever we go to exchange an asset or a token for another, there needs to be enough tokens available to be traded on both sides, this is considered liquidity. The more liquidity a trading pair has, the easier an order can get filled at a reasonable price.
In centralized exchanges/platforms, oftentimes market makers are employed to provide this liquidity. They are paid with a portion of the transaction fees that traders pay the exchange when trading. Because we are now moving to the decentralized world, anyone can participate in being a market maker and can earn rewards for doing so just like traditional market makers.
As stated above, the primary way to earn from Liquidity Pools is by staking your crypto in the pool to serve as a market maker. Liquidity Pools, like the ones in Flare Finance, require a 50/50 token split. What does that mean? For a given Liquidity Pool, there are two assets that you must stake tokens for. If we enter a XRP/USD Liquidity Pool, we must stake both XRP and USD to participate. With a 50/50 split pool, we must stake and maintain an equal amount of value on each side. This does not mean that the token quantities are the same, just the value they represent. Let’s say the price of 1 XRP is currently $0.50 USD, then we will have to put up 2 XRP for every 1 USD to represent an equal value on both sides of the pool.
Earning rewards from the pool as a participant, or Liquidity Provider, comes from when traders swap from one token to the other in the Liquidity Pool you are staking your tokens in. The traders pay a transaction, or exchange fee to trade, and you as the Liquidity Provider earn a portion of those fees as rewards. This is, at its core, how you can earn from participating in Liquidity Pools.
You earn these fees in the form of what are called LP tokens or Liquidity Provider tokens. LP Tokens are denominated in the pairing that you provided liquidity for. In our example, we would be earning XRP/USD LP tokens. The amount of LP tokens you earn is directly proportional to the amount of value you stake, relative to the total amount that exists in the pool. For example, if you staked $10 USD worth of value in the XRP/USD Liquidity Pool that has a total of $100 USD locked in it, you will be earning 10% of the pool's LP token rewards. LP tokens can be redeemed for their value in each asset (XRP/USD) or can be used in other products in DeFi applications such as Yield Farming in Flare Finance's FlareFarm application.
Currently, Flare Finance will be one of the first DeFi platforms to offer its users the chance to participate in Liquidity Pools on the Flare Network. From their whitepaper, all Liquidity Pools will be a 50/50 token split as described in the previous section. These Liquidity Pools will help provide liquidity for their FlareX product which acts as a decentralized exchange on the Flare Network. The FlareX platform utilizes smart contracts to provide automated market makers (AMM) with liquidity and allows its users to swap tokens and trade on margin. Find out more about Flare Finance and their offerings here.