What is a Liquidity Pool?
A liquidity pool is a fundamental component of decentralized exchanges (DEXs) and other DeFi protocols. It serves as the foundation for transacting various cryptocurrencies without the need for traditional intermediary such as a centralized exchange.
How do Liquidity Pools Work?
Liquidity Deposits
Liquidity pools consist of two tokens paired together. For instance, AVAX/USDT, or AVAX/WETH, AVAX represents one pair, and USDT/WETH represents the other. A user can deposit an equal value of each token into the pool to create a balanced liquidity pool.
Trading Facilitation
Users use these liquidity pools to exchange better known as swapping, one token for another. When a swap occurs, the user pays a small fee, which is distributed among the liquidity providers that participate in the liquidity pool. The exchange rate between the two tokens in the pool adjusts automatically based on supply and demand.
Impermanent Loss
Liquidity providers assume the risk of impermanent loss. This occurs when the monetary value ratio between the two tokens inside the pool changes significantly from the time the tokens were deposited by the wallet holder. To learn more, visit our article on impermanent loss.
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