With the launch of PulseX, the primary decentralized exchange (DEX) of PulseChain, many are seeing the incredible opportunity of liquidity providing and wanting to get started. This post is to help people better understand how liquidity pools on PulseX work.
You can watch this short explainer video, or scroll past for the written post:
The Basics of PulseX
Before we dive into the specifics of liquidity pools, it’s crucial to understand the overall concept of PulseX. PulseX is a permissionless and decentralized exchange that enables users to trade any pair of PRC-20 tokens directly with each other, bypassing the need for order books traditionally used in other exchanges.
The core feature that sets PulseChain apart is its use of liquidity pools instead of order books to make trades possible. To comprehend how PulseX’s liquidity pools work, you first need to grasp the concepts of Liquidity Providers (LPs) and Automated Market Makers (AMMs).
Liquidity Providers and Automated Market Makers
In a PulseX liquidity pool, users (known as Liquidity Providers) deposit an equal value of two tokens, creating a pool for others to trade against. By providing liquidity, LPs earn fees from the trades that happen in their pool, proportional to their share of the pool.
The pricing of tokens in each pool is determined by a mechanism called the Automated Market Maker (AMM). The AMM algorithm maintains the balance of tokens in the pool using a formula that adjusts the price of tokens based on their supply and demand.
The Constant Product Formula
PulseX employs the ‘Constant Product Market Maker’ model, defined by the equation x*y=k, where x and y are the quantities of the two tokens in the liquidity pool, and k is a constant value. This equation implies that the product of the quantities of two tokens in the pool must remain constant.
This constant product formula results in a unique pricing mechanism. When a user wants to buy a particular token, they increase the demand, thereby increasing the price. Similarly, if a user sells a token, the supply increases, reducing the price. This model ensures that as the quantity of one token decreases in the pool, the other increases, maintaining the balance.
The Benefit and Risks for Liquidity Providers
By providing liquidity, LPs earn a 0.22% fee on all trades proportional to their share of the pool. These fees are added to the pool, accruing in real-time, and can be claimed by withdrawing their liquidity.
PulseX also offers an incentive program to provide liquidity in certain pools. When providing liquidity for these pools, you’re able to then stake your LP tokens and earn the incentive token, INC. This innovative incentive program provides a great opportunity for liquidity providers to earn more yield and improves the experience for traders by increasing the size of the pools, thereby reducing slippage.
However, providing liquidity isn’t without risks. One significant risk is ‘Impermanent Loss.’ It occurs when the price of tokens inside the pool diverges in any direction from when they were deposited. The more significant this divergence, the larger the impermanent loss. It’s important to note that impermanent loss is only truly experienced when you exit an LP by burning your LP tokens and receiving your coins at the current ratio. Although trading fees and INC earnings can help offset some of these losses, it’s not always guaranteed.
