Understanding Liquidity Pools and Liquidity Providers

4 minute read

Liquidity Providers can add funds/assets into a liquidity pool that allows traders to swap assets. Liquidity Providers stake assets as they can get a good return on the amount they invest. While BepSwap is used in this example, it applys to most liquidity pools.

General Terms

First, what is a Liquidity Pool? Liquidity is another term for money or funds that are accessible, like cash on hand - it can be accessed quickly. A Pool of funds is a collection of funds in one place - like a pool of water in a swimming pool. Liquidity Pool means a collection of accessible funds in one spot. The amount of funds in a pool is called its depth, just like a real pool. So, the greater amount of funds in the pool, the deeper the pool.

A Liquidity Provider is someone who provides funds to the liquidity pool. Adding funds or assets to a pool is known as staking or staking your assets.

It can get a bit complex from here, so I will give a real world relatable example.

Your local currently exchange would have a bunch of dollars in different currencies like USD, AUD, Pound and so on. Say I am in Australia and I want to travel to America, I would go to my local currency exchange and swap my AUD for USD at a conversion rate they set - usually a bit less than the actual exchange rate as the local currency exchange wants to make a profit. So now I have swapped one currency for another currency.

In this case, as the local exchange has provided the AUD and USD for swapping, as a company, they are considered to be the liquidity provider. I might want to swap it back later - so they actually need to hold AUD and USD. They are a company that holds funds to serve people who want to swap currencies, say for travelling to a different country. They might support many different currencies also like Pound, ERO, YPN - but is always done in a pair, in our situation AUD and USD.

Binging it back to Crypto

With something like BepSwap, many people have pooled their assets together into one place to allow other people to swap one cryptocurrency for another cryptocurrency. Note that in this case, it is not one company providing the liquidity, it is provided by many different people - e.g. it is not centralised, it is distributed or decentralised. In addition, like the AUD and USD example, crypto liquidity providers also need to stake 2 different assets of equal value to create a pool. Thus, a pool of a $1000 value will have a 50/50 split of two assets each to the value of $500.

Looking at a BepSwap pool, this would be the Binance Chain native token aka Binance Coin and Rune Liquidity pool with 50% Binance Chain native token and 50% Rune. You can then use this pool to swap Rune for Binance Coin or vice versa. The same principle applies to all pools.

Staking and Income

Liquidity Providers stake their assets to receive the fees from the people who swap assets. Like with the local currency exchange, the person swapping the asset incurs a fee for doing so which is passed on to the liquidity providers.

It could be said liquidity providers are the same as the local currency exchange in our example, to the degree of the amount of funds they have contributed to the pool. Thus, if their contribution makes up 40% of the pool depth, they are like 40% of the exchange, and will receive about 40% of any fees incurred by the person who swaps assets using that pool.

Or put another way, people can use BepSwap to swap one BEP2 asset for another BEP2 asset, for example, swap Rune for Binance Coin and the people who provide the liquidity get to take the fee.

Lastly, liquidity providers can withdraw or un-stake their assets at any time, taking any profits they may have received while staking their assets.

Liquidity Providers can stake assets into a liquidity pool which allow traders to swap assets. Liquidity Providers stake assets as they can get a good return on the amount they invest.

To sum up

Liquidity Pools are not new - they have been happening within the Ethereum space for a very long-time using systems such as UniSwap - there are so many, however it is all confined to the Ethereum ecosystem.

BEP2 assets are confined to the Binance ecosystem. Because each asset is confined to its own ecosystem, BepSwap is providing the same function in Binance as UniSwap does on Ethereum.

Currently there is no way for assets to natively cross ecosystems. While workarounds exist, there is no actual solution and this is the ultimate problem THORChain aims to achieve. But more on that in another video.

I hope this gives you an understanding of the basic concepts.