What exactly is a Liquidity Pool
What is a 'V1' Liquidity Pool
How to add Liquidity
How to remove Liquidity
How does a Liquidity Pool Work?
A liquidity pool (LP) is a smart contract that holds two tokens, e.g. ETH and USDC tokens. Liquidity Pools are there to facilitate trading between the two tokens that are inside of the Liquidity Pool. Liquidity Pools therefore replace the need for Market Makers that facilitated trading on centralised exchanges. A decentralised exchange therefore uses an automated market maker (AMM), which is an algorithm executed by smart contracts that completes swaps which are performed by users on the decentralised exchange.
To summarise: A Liquidity Pool is what allows users to exchange between the two tokens automatically and in a permissionless manner using smart contracts.
What is a V1 Liquidity Pool
The V1 protocol is different to the Liquidity Book Protocol, both protocols are combined to offer different types of Liquidity Pools on the Trader Joe DEX but in short, the V1 protocol keeps an automated ratio of 50/50 tokens in a Liquidity Pool whereas Liquidity Book lets Liquidity Providers choose and manage any ratio of tokens inside a Liquidity Pool.
Why Deposit Liquidity into a Liquidity Pool?
Users do this so they can earn a share of the trading fees by depositing a pair of tokens into the LP (also known as "adding liquidity"). Users will receive an LP token, representing their share of the LP and that share of the LP entitles them to a proportionate share of any fees accrued.
Pool APR is the yield you accrue by adding liquidity to a Pool. V1 Liquidity Pools take 0.3% of all trading volume as fees. Of this 0.3%, 0.25% is shared between all Liquidity Providers and 0.05% is distributed to sJOE. Fees are added to the pool, accrue in real-time, and are automatically added onto your liquidity when you withdraw your liquidity from the Liquidity Pool. Providing liquidity is not without risk, as you may be exposed to impermanent loss (IL).
Tutorial: How to add Liquidity to a Pool?
Go to the Pools page
Find your prefered liquidity pool, this will depend on the tokens you hold
Click into the Pool to enter the Pool page (image below)
Add your Tokens by selecting quantities, this will need to be a perfect 50/50 ratio
Click Approve/Confirm to initiate the Transaction in your Wallet
Done! You are now earning your share of Trading Fees generated by the Pool!
Tutorial: How to Remove Liquidity from a Pool?
Head to the Pool you wish to remove tokens from and hit 'Remove Liquidity'. Now enter the required Tokens to remove or use one of the pre-selected % buttons (The ratio of tokens needed will be automatically filled). Once you have selected the amount to remove, you will need to approve the transaction in order to remove the Tokens. Your wallet will provide you with Confirmation requests, once completed you will have your original Tokens back in your wallet.
Impermanent Loss (IL)
Providing Liquidity comes with a risk of Impermanent loss. This occurs when you provide liquidity to a pool containing two different assets in equal value.
What is Impermanent Loss?
When you deposit assets in a liquidity pool, their ratio is set at 50/50.
If the price of one asset changes compared to when you deposited, the ratio of assets in the pool changes to maintain a balance.
This can lead to 'impermanent loss' because the value of your deposited assets may become less than if you had just held onto them separately.
Impermanent Loss is not permanent and it can be reversed if more fees are earned on the position
Impermanent Loss is only permanent, when you withdraw from a Liquidity Book, you are essentially crystallizing those losses.
Your Risk as a Liquidity Provider
Price Volatility: The greater the price change of one asset relative to the other, the larger the potential impermanent loss. This is a significant risk in volatile markets.
Opportunity Cost: You might lose out on potential gains you could have had if you simply held the assets outside the pool.
Temporary Nature: The loss is 'impermanent' because it only realizes if you withdraw your assets from the pool. If prices return to their original levels when you entered the pool, the loss can be reversed.
Dependent on Pool Dynamics: The extent of impermanent loss depends on the specific dynamics and rules of the liquidity pool you're participating in.
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