Important note: Nothing in this post if Financial advice - it should be used as a learning tool to understand what Liquidity pools are, and how they are used.

What is a liquidity Pool?

For the sake of simplifying things - I going to say a Liquidity Pool(LP) is a shared "Toybox" between you and a friend. Inside this toybox is common Pokémon Cards and Magic the Gathering (MtG) cards. both you and your friend put in 100 cards each - meaning the pool has 200 cards. Other people are able to swap their Pokémon and MtG cards at a rate of 1:1 - one Pokémon card is equal to one MtG card.

Each time someone swaps a card, let's say the "fee" is 2 Lego bricks. it doesn't matter who's card is taken from the LP - both you and your friend receive one Lego brick as the reward for providing the cards in the LP.

This example assumes the value of both Pokémon cards and MtG cards is the same. a similar comparison in crypto would be a LP of USDC/USDT. the value of each is theoretically identical, but people will swap between them depending what Dapp they are using, and what the Dapp accepts.

So - what happens if there's an influx of people wanting Pokémon cards? more and more people will trade their MtG cards for Pokémon, and eventually your contribution to the LP will be 100 percent MtG cards.

At this point: you cannot participate in trades anymore because all of the in demand Pokémon cards in your pool are gone - your contribution to the LP is "out of range". Thus, you aren't earning anymore Lego blocks, because your MtG cards aren't being used in trades.

Timmy and Samantha see your idea, and decide to keep it going. they add 100 Pokémon cards and 100 MtG cards of their own to the pool. however, because Pokémon cards are in demand - they set the trade value to 2 MtG cards for 1 Pokémon card. Because Timmy and Samantha have added the Pokémon cards -the entire fee of 2 Lego blocks will go to them.

You might ask "but our Magic cards are also in the pool - what if the magic cards are used? well the Toybox knows who put what in, and knows that while the value of Pokémon cards is 2 MtG cards- your cards will not be touched or used. When people are bored of Pokémon, and begin trading for Magic again, everyone will take advantage of Timmy and Samantha's 1 Pokémon card for 2 MtG card trade. Eventually, they will have no MtG cards left, so people will resort to trading 1:1 from your pool, and you will start collecting fees again.

Let's take the above, and put it into a real world Crypto situation. In the below graph, I have deposited my Pokémon and Mtg Cards (USDC and AVAX) into the pool. I have said that while the price is between $24 and $27, I'm happy for my AVAX and USDC to be traded to others, and collect the Lego brick (BLACK Token in this instance) as a reward for doing so.

If the value of AVAX falls below $24 because there is more demand for USDC than AVAX, i will have a full toybox of AVAX, and collect no more BLACK token. Similarly, if the value of AVAX goes above $27 because the demand is high, I will have a full toybox of USDC.

This brings be on to explaining Impermanent loss (IL). Back to the trading card analogy:

One day, Pokémon cards become super rare and now each is worth $2, while MtG cards stay at $1. Outside the toybox, if you had just held your 100 Pokémon and 100 MtG cards instead of putting them into the toybox, you would have:

• 100 × $2 (Pokémon) = $200

• 100 × $1 (MtG) = $100

• Total: $300

But... As people trade MtG cards for Pokémon cards (because Pokémon are more valuable), your Pokémon cards get taken out and replaced by more MtG cards. The pool rebalances to maintain a 50/50 value ratio.

Let’s say after all the swaps, your share of the pool now consists of:

• 70 MtG cards

• 35 Pokémon cards

At current market prices:

• 35 Pokémon × $2 = $70

• 70 MtG × $1 = $70

• total: $140

Even though you may have earned 100 Lego bricks (let's say the value of these is $0.1 each) - the value of your reward is $10 total - meaning you would have been better off financially to simply hold the cards instead of selling them.

In Crypto terms: If AVAX goes above $27 a token, I will have $27 in USDC. if the price of AVAX goes to $50, i still only have $27 in USDC, meaning i would have been better off holding the AVAX instead of putting it into the pool

Liquidity pools are a wonderful thing, and are the heart and soul of Crypto and defi. Used appropriately, they can be used to maximize earnings on tokens sitting in your wallet. it's just important to make sure you take precautions, and understand where you're putting your money before doing so.

I hope this kind of explains Liquidity pools. Let me know if you want a part 2, which explains APR's, and more complex situations surrounding LP's.

Important note: Nothing in this post if Financial advice - it should be used as a learning tool to understand what Liquidity pools are, and how they are used.

What is a liquidity Pool?

For the sake of simplifying things - I going to say a Liquidity Pool(LP) is a shared "Toybox" between you and a friend. Inside this toybox is common Pokémon Cards and Magic the Gathering (MtG) cards. both you and your friend put in 100 cards each - meaning the pool has 200 cards. Other people are able to swap their Pokémon and MtG cards at a rate of 1:1 - one Pokémon card is equal to one MtG card.

Each time someone swaps a card, let's say the "fee" is 2 Lego bricks. it doesn't matter who's card is taken from the LP - both you and your friend receive one Lego brick as the reward for providing the cards in the LP.

This example assumes the value of both Pokémon cards and MtG cards is the same. a similar comparison in crypto would be a LP of USDC/USDT. the value of each is theoretically identical, but people will swap between them depending what Dapp they are using, and what the Dapp accepts.

So - what happens if there's an influx of people wanting Pokémon cards? more and more people will trade their MtG cards for Pokémon, and eventually your contribution to the LP will be 100 percent MtG cards.

At this point: you cannot participate in trades anymore because all of the in demand Pokémon cards in your pool are gone - your contribution to the LP is "out of range". Thus, you aren't earning anymore Lego blocks, because your MtG cards aren't being used in trades.

Timmy and Samantha see your idea, and decide to keep it going. they add 100 Pokémon cards and 100 MtG cards of their own to the pool. however, because Pokémon cards are in demand - they set the trade value to 2 MtG cards for 1 Pokémon card. Because Timmy and Samantha have added the Pokémon cards -the entire fee of 2 Lego blocks will go to them.

You might ask "but our Magic cards are also in the pool - what if the magic cards are used? well the Toybox knows who put what in, and knows that while the value of Pokémon cards is 2 MtG cards- your cards will not be touched or used. When people are bored of Pokémon, and begin trading for Magic again, everyone will take advantage of Timmy and Samantha's 1 Pokémon card for 2 MtG card trade. Eventually, they will have no MtG cards left, so people will resort to trading 1:1 from your pool, and you will start collecting fees again.

Let's take the above, and put it into a real world Crypto situation. In the below graph, I have deposited my Pokémon and Mtg Cards (USDC and AVAX) into the pool. I have said that while the price is between $24 and $27, I'm happy for my AVAX and USDC to be traded to others, and collect the Lego brick (BLACK Token in this instance) as a reward for doing so.

If the value of AVAX falls below $24 because there is more demand for USDC than AVAX, i will have a full toybox of AVAX, and collect no more BLACK token. Similarly, if the value of AVAX goes above $27 because the demand is high, I will have a full toybox of USDC.

This brings be on to explaining Impermanent loss (IL). Back to the trading card analogy:

One day, Pokémon cards become super rare and now each is worth $2, while MtG cards stay at $1. Outside the toybox, if you had just held your 100 Pokémon and 100 MtG cards instead of putting them into the toybox, you would have:

• 100 × $2 (Pokémon) = $200

• 100 × $1 (MtG) = $100

• Total: $300

But... As people trade MtG cards for Pokémon cards (because Pokémon are more valuable), your Pokémon cards get taken out and replaced by more MtG cards. The pool rebalances to maintain a 50/50 value ratio.

Let’s say after all the swaps, your share of the pool now consists of:

• 70 MtG cards

• 35 Pokémon cards

At current market prices:

• 35 Pokémon × $2 = $70

• 70 MtG × $1 = $70

• total: $140

Even though you may have earned 100 Lego bricks (let's say the value of these is $0.1 each) - the value of your reward is $10 total - meaning you would have been better off financially to simply hold the cards instead of selling them.

In Crypto terms: If AVAX goes above $27 a token, I will have $27 in USDC. if the price of AVAX goes to $50, i still only have $27 in USDC, meaning i would have been better off holding the AVAX instead of putting it into the pool

Liquidity pools are a wonderful thing, and are the heart and soul of Crypto and defi. Used appropriately, they can be used to maximize earnings on tokens sitting in your wallet. it's just important to make sure you take precautions, and understand where you're putting your money before doing so.

I hope this kind of explains Liquidity pools. Let me know if you want a part 2, which explains APR's, and more complex situations surrounding LP's.