Liquidity Pools

Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price

In summary

• Liquidity pools are pools of tokens that are locked in a smart contract. By offering liquidity, they guarantee trading.

• Liquidity pools are essentially the trading aspect of a decentralised exchange.

• Without liquidity, a single trade could move the price in one direction causing volatility. This isn't great for investors.

• Liquidity pools provide an easy to use platform for both users and exchanges.

• Scallop has its own liquidity pool SCLP-BNB available on Pancakeswap. A guide on getting involved is available here

What are liquidity pools

A liquidity pool is a collection of funds locked in a smart contract.

Liquidity pools are essential in the functioning of decentralised trading and lending. Users called liquidity providers (LP) add an equal value of two tokens into a pool, creating a market. For doing so, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity. The LP receives special tokens called LP tokens in proportion to how much liquidity they provide to the pool.

SCLP has a liquidity pool of its own. SCLP-BNB on pancake swap - learn more here

To reclaim their initial tokens the user burns the LP tokens and are given back their original tokens. Liquidity Providers earn fees from the trades that happen in their pool.

How do liquidity pools work

Automatic Market Makers (AMM) will quote a price that buyers can purchase and sell assets from the liquidity pool - these algorithms vary amongst LP's but they will always quote a price and 'make a market' to buy and sell from, hence the name. This is an innovation that has moved away from traditional order books where other users buy and sell directly off other users, or peer to peer. Trading with an AMM can be considered peer-to-contract.

Why do projects use liquidity pools?

Distributing new tokens into the hands of the right people is a very difficult problem for crypto projects, including here at Scallop. Liquidity mining solves this issue. This involves distributing the tokens algorithmically to users who put their tokens into a liquidity pool. Then, the newly minted tokens are distributed proportionally to each user’s share of the pool. This is the approach at SCLP, and it rewards our backers with newly minted tokens.

Advantages of liquidity pools

Guaranteed liquidity at any price level: Traders do not need to be directly connected with other traders as liquidity is always available.

Automated Pricing Enables Passive Market Making: Liquidity providers put their money into the pool and the pricing is controlled by the pool’s smart contract and AMM's.

Anyone can become and earn a liquidity provider: Liquidity pools do not require listing fees, KYCs or other obstacles associated with centralised exchanges. If an investor wants to provide liquidity to the pool, he just needs to deposit his assets.

Dangers

Impermanent loss - essentially where the holding of two assets results in lower profit than holding the outright assets.

Possible smart contract bugs - leading to loss of assets

Liquidity pool hacks - a danger in any crypto project.

We will be doing a series on cryptocurrency safety, how to spot scams and how to look after your crypto!

Summary

Liquidity pools are a cornerstone of the Defi ecoysystem. they enable decentralised trading, lending, yield generation. They are a great way for projects to distribute tokens to the right investors too.