Liquidity Pools Explained: Price Discovery for Play to Earn Tokens

Liquidity pools use smart contracts to settle the price for new tokens, while paying passive returns for locking in assets.

Liquidity pools are already a well-established structure for cryptocurrency projects. A liquidity pool is established when token owners agree to lock up their assets, usually in a pair between two coins or tokens. 

That pair of assets, based on their ratio, can establish the price for the tokens and serve as a trading mechanism. The token owners will usually receive rewards for locking in their tokens, as an incentive not to rush and panic-sell. This allows for an automated price discovery mechanism and an immediate exchange venue for newly created tokens. 

Almost all big blockchains support their native liquidity pools, usually organized as a decentralized exchange. UniSwap is the go-to exchange for Ethereum, PancakeSwap serves the Binance Smart Chain tokens, and Pangolin DEX for the Solana network. SunSwap serves TRON network, and there are many other leaderless markets that operate on automated trading. 

Why Liquidity Pools Boost Play to Earn Token Prices

Earning a reward token raises the matter of needing to liquidate the rewards. Not all brand-new tokens will be listed on exchanges, and liquidity pools are one source of price discovery. 

The other effect of liquidity pools is that they incentivize some of the players not to sell their tokens immediately. Holding onto native reward tokens and using them within the game can translate into increased value. 

Liquidity pools also require the second asset in the pair to be in a sufficient quantity. For instance, a token may require a certain amount of ETH to be injected into the pool to support valuations. 

A well-supplied liquidity pool is a good sign when vetting a play to earn project. Some platforms will also provide their own liquidity in ETH or BNB tokens. 

What are the Risks of Liquidity Pools

Putting assets into a liquidity pool, also known as liquidity mining, holds significant risk. The main source of losses is the so called impermanent loss, which leaves some token holders with less paper value. Impermanent loss can recover over time. 

Liquidity pools are also risky when they are deliberately rug-pulled, that is, when a token owner abuses the available liquidity and sells, crashing the market price. 

The best approach is to be aware of those risks before committing a reward token to a liquidity pool. For more reliable projects, a robust, well-supplied liquidity pool with high trading activity can be a sign for a viable play to earn ecosystem.

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