What Are Liquidity Pools?

Liquidity pools are the backbone of many decentralized exchanges (DEX), such as Uniswap. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.

Whenever you swap one token for another on Uniswap you are actually trading with an investor who has locked up a large lump sum of tokens on the Uniswap platform. This large lump sum of tokens is called a liquidity pool and investors create pools because they are rewarded the fees that a user pays when they swap one token for another. For investors a liquidity pool is an investment tool and for regular Uniswap users liquidity pools are the reason it is so easy to trade one token for another.

Keywords

  • Automated Market Maker (AMM) - You could think of an automated market maker as a robot that’s always willing to quote you a price between two assets. Uniswap provides this AMM robot for you so that you can use a simplified interface to add liquidity to existing robots. You just have to select a crypto pair (ie USDC/ETH), a price range you want to provide liquidity for (ie $1,800 - $2,000 USDC/ETH), and deposit both of the tokens in whatever amount you can afford. The more tokens you provide the bigger share of the fees you will receive. If you're the only user providing liquidity in a pool or at a specific range you will receive 100% of the fees.
  • Fees - If Liquidity Pools and AMMs are the backbone of Uniswap then it's swapping functionality is the face. Most users interact with Uniswap to trade (or swap) one token for another and they are charged a fee by Uniswap everytime they preform one of these trades. So if you are a liquidity provider you get a portion of the fees charged on every swap. This is the main incentive for an LP to provide liquidity in the first place.
  • Impermanent Loss - Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. Let's say you open a pool with USDC/ETH and the price of Ethereum drops drastically and goes out the bottom of your selected range. You will now be holding 100% Ethereum and the total value will be less than what you initially put into the pool. The reason it's called impermanent loss is because the loss is not realized (or permanent) until you actually pull the liquidity from the pool. In the scenario where the price of Ethereum drops, you could leave the liquidity in the pool and the price of Ethereum may go back up and reach the same value as when you put it in. If you waited and this occurred you could pull your liquidity then and realize no loss. The loss only becomes permanent when you realize it.

How Do I Create A Liquidity Pool On Uniswap V3?

Finding A Pool

You can create your own Liquidity pool or add liquidity to an existing one. The benefit of joining an existing one is that Uniswap will show you analytics on the performance of the pool and it allows you as investor to make a more informed decision on your potential returns.

Visit https://info.uniswap.org/#/pools to see a list of the top liquidity pools on Uniswap. You'll be able to sort by Total Value Locked (TVL), 24 hour volume, or 7 day volume. The small percentage value next to the title is the percentage fee that the liquidity pool has chosen to charge users who swap using that pool. This is why you when you use Uniswap to trade assets you are charged a different percentage fee depending on what assets you're swapping and at what time. The fee is decided by the liquidity provider when they create the pool. An LP wants to make the fee high enough so they turn a profit but low enough that a competing liquidity pool can't come in at a lower fee percentage and take more of the transactions away from them.

Reviewing Pool Details

After you've chosen a pool you can select the list item to enter the detailed view.

You'll want to use the information provided here with your own technical analysis to select a range to deploy your liquidity into.

When the price of the assets are within your range you'll be providing liquidity to Uniswap users and collecting fees. You'll also be sharing the fees with any other LPs in your range. As soon as the price of the assets goes above or below your set range you will no longer receive any fees. If/when the price re-enters the range you'll automatically be providing liquidity again and receive fees.

A good starting point to determine which range you should choose is to view the liquidity chart in the detail view. This chart gives you a visual representation of which ranges other LPs are providing liquidity for as well as the quantity. So as an easy first strategy you could simply copy the most popular range from the charts for your own liquidity.

From the chart above it looks like most of the liquidity is being provided in the $2,203 to $2,399 range, so this is where we will set our range for this example.

Another great aspect of these charts is that you can see what other investors are predicting the price of an asset will do based on which side of the current price most of the liquidity is being deployed. In this chart it appears investors have a slightly bearish outlook. More investors think Ethereum is going to face resistance at its current price.

Adding Liquidity

The interface for adding liquidity is pretty basic. We've already selected our range so we enter it in the Min/Max Price section. Then we add however much we want of the assets proportional to their value and click "Add".

Only add the liquidity you're willing to risk this is an investment product you can make money as well as loose it. If you need to trade one token for another you can always use the main Uniswap application to get the correct ratio of assets you need to start the pool https://app.uniswap.org/#/swap.

Managing Open Pool

Once you've created your pool you'll be brought to a custom page just for your position in the pool with your very own NFT that represents your assets. Don't send this NFT to anybody, because if you do they will now have control over your pool and all of the assets locked inside.

You should check this page periodically to see the fees you've collected and make sure that the price is still within your range. If at any point you'd like to take your earnings and leave you can do so by clicking "Remove Liquidity".

Conclusion

Liquidity pools provide a great service to crypto currency users as well as investors who want a healthy return on their investments. Like any investment tool you should do your research and only take as much risk as you can handle.

That being said this is a very new and exciting technology and I encourage anyone who is interested to simply put a small amount of money into them and kick the tires a little. Put in a small amount you're not worried about loosing so that you can really try out different strategies and get a feel for how the market operates. Experimenting like this is very important, don't just blindly listen to any financial advisor, TRY THESE THINGS OUT FOR YOURSELF FIRST!

Thanks for listening crypto fam. Love you long time!

PS: Difference Between Uniswap V2 And Uniswap V3

V2

V2 LPs only earn fees on a small portion of their capital, which can fail to appropriately compensate for the price risk (”impermanent loss”) they take by holding large inventories in both tokens. Additionally, traders are often subject to high degrees of slippage as liquidity is spread thin across all price ranges.

V3

In Uniswap v3, LP’s can concentrate their capital within custom price ranges, providing greater amounts of liquidity at desired prices. In doing so, LPs construct individualized price curves that reflect their own preferences.

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