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What is a liquidity pool?
A liquidity pool is a digital pool of cryptocurrency locked in a smart contract. This allows for the creation of liquidity which facilitates faster trading.
A major component of a liquidity pool is automated market makers (AMMs). An AMM is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.
AMM platforms allow users to supply tokens to liquidity pools in return for trading fees and liquidity mining incentives.
Liquidity pools are designed to incentivize users to provide liquidity, hence the name 'liquidity providers' (LPs). After a certain amount of time, LPs are rewarded trading fees and incentives relative to their stake in the pool. This allows a liquidity provider to collect trading fees in return for taking on a higher risk.
In a trade, traders or investors can encounter a difference between the expected price and the executed price. That is common in both traditional and crypto markets. The liquidity pool aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.
Trades with liquidity pool programs like SumSwap don't require matching the expected price and the executed price. AMMs, which are programmed to facilitate trades efficiently by eliminating the gap between the buyers and sellers of crypto tokens, making trades on decentralised exchanges easy and reliable.
A Sumero pool is a smart contract that implements the SumSwap decentralised exchange. SumSwap allows for the buying and selling of ERC-20 tokens, including synthetic assets.
As mentioned above, a typical liquidity pool motivates and rewards its users for staking their digital assets in a pool. Rewards can come in the form of crypto rewards or a portion of trading fees from pools where they deposit their assets in.
Here is an example of how that works, with a trader investing $20,000 in a USDC-CLAY liquidity pool using SumSwap.
The steps would be as follows:
- Go to SumSwap.
- Find the USDC-CLAY liquidity pool.
- Deposit a 50/50 split of USDC and CLAY to the pool. In this case, you would deposit $10,000 worth of USDC and $10,000 worth of CLAY.
- Receive USDC-CLAY liquidity provider tokens.
- Deposit these LP tokens into the USDC-CLAY staking pool.
- Earn additional Clay tokens as a reward for staking your LP tokens.
The USDC-CLAY pair that was originally deposited would be earning a portion of the trading fees collected on SumSwap from that liquidity pool. In addition, you would be earning CLAY tokens in exchange for staking your LP tokens.