How Liquidity Pools Think
How Liquidity Affects A Trade 🌊
Imagine if there are 2 separate DEX’s that will allow you to swap BANANA and BUSD but they have vastly different liquidities.
- DEX 1 has 10,000 BANANA and 10,000 BUSD
- DEX 2 has 10 BANANA and 10 BUSD
Because the price of BANANA is determined by the ratio of tokens in the liquidity pool, we can see that both DEX’s currently price their BANANA at 1 BUSD each.
🅰 DEX 1
Now, if an investor goes up to DEX 1 and were to sell 1 BANANA into the pool in exchange for 1 BUSD, the pool would now contain 10,001 BANANA and 9999 BUSD. Based on the new ratio, each BANANA is now only worth 0.9998 BUSD [9999 BUSD /10,001 BANANA].
If that same person continues to sell another BANANA for BUSD, he’d only receive 0.9998 BUSD. The pool now stands at 10,002 BANANA and 9998.0002 BUSD, which further drops the price of BANANA to 0.9996 BUSD.
🅱 DEX 2
Were the same investor to go to DEX 2 to sell his 2 BANANA however, things would have worked out very differently. Selling his first BANANA for 1 BUSD, the liquidity pool is now left with 11 BANANA but only 9 BUSD. Based on the new ratio, each BANANA is now only worth 0.818 BUSD [9 BUSD / 11 BANANA].
Selling the second BANANA would then see the investor receiving 0.818 BUSD and causing the price of BANANA to further plunge to 0.6818 BUSD [8.182 / 12 ] as the liquidity pool currently has 8.182 BUSD and 12 BANANA.
The Result ✅
Selling 2 BANANA in DEX 1 sees the investor walk away with 1.9998 BUSD while doing the same in DEX 2 will only net the investor a total of 1.818 BUSD.
This was a simple example with the investor only selling 2 BANANA, but continue the example with the investor selling a 3rd, 4th or 8 BANANAS and hopefully you’ll begin to see just how important liquidity is to a DEX. Due to the lower liquidity in DEX 2, the price of BANANA within DEX 2 suffered from a much higher price impact for each trade, which resulted in the investor receiving far less than what he would have received in DEX 1.