Liquidity Pool pricing mechanics

Liquidity Pools are an important cryptomarket innovation which allows DEXes (Decentralised Exchanges) to operate using AMMs (Automated Market Makers).

This AMM innovation effectively allow the entire cryptomarket to operate as one large integrated global digital currency, automatically connecting all of the tokens based on their market value. There are already bots roaming all tokens looking for arbitrage opportunities to keep market values between different pairs in line.

In the past centralised exchanges were order driven systems were liquidity providers provided bids to but at a certain price and offers to sell at a higher price. This would result in a spread between buyers and sellers. In addition, buyers could take an offer and sellers could take a bid.

The new AMM approach is more efficient as liquidity providers commit to buying and selling at the current market price, in return for a share of the transaction fees which is effectively a spread.

The market price is the ratio of the total number of tokens deposited into the liquidity pool. For example if there are 10m Polar and 1m BUSD deposited as liquidity, the Polar price would be USD0.10 (1m/10m).

If someone then bought 100,000 Polar by swapping for 10,000 BUSD, then the new market price would have risen by USD0.102 based on the new liquidity ratio of 1,010,00 / 9,900,000. Note that this is a simple example, but the buyer and liquidity pool would have settled at a price in between this starting and ending price position.

Binance Academy provide an excellent tutorial on Liquidity Pools

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