Intro to Liquidity Pools (LPs)

Liquidity pools (LPs)

A Liquidity Pool is behind every DEX pair.

These are decentralized stores of coins (i.e. virtual reservoirs or vaults) contributed to by LP depositors. Anyone can deposit their coins to contribute to a liquidity pool.

The usual design of a liquidity pool consists of the pooling of two assets in a 50:50 ratio by value. For example, if BTC is valued at $50,000 and THORChain’s token RUNE is valued at $5, a balanced pool will have 10,000 RUNE for every 1 BTC. 

When traders/swappers utilize an LP to perform a decentralized swap, the trader will pay a small fee. This fee is distributed back into the LP (and thus all LP depositors) based on the share of the pool. This is the earning/rewards for the contribution of the liquidity. Depositors are also free to withdraw their coins from the LP at any time.

One crucial aspect to understand before participating in an LP is the concept of Impermanent Loss, which will be covered in another lesson. Liquidity Pools are great for earning yield and enabling swaps, though keep in mind that LP’ing does not guarantee a consistent return; an LP’s success always depends on the price movement of the assets and the activity and volume in the pools.