So it was a bit complicated for me to understand at first. But after messing around with it, I think I have a fundamental understanding of the system.
When you provide liquidity to a pair, lets say (PRV - ETH), your basically buying into the liquidity pool. You receive shares equal to the percent ownership of the liquidity pool.
Since your providing 50% PRV and 50% ETH, the price that everything was when you bought into the liquidity pool is locked in place.
This obviously isn’t good if the price of ETH goes significantly up compared to the price of PRV. You would be losing money.
However, since your buying shares in the liquidity pool, when the price changes, and somebody else provides liquidity at a different rate, the price in the pool averages out. The more people providing liquidity, the more stable the price is.
So if you lose money, as long as more people provide liquidity and average the price back out, you should be fine. The liquidity pool is also gaining from staking PRV as well as transaction fees. This get’s rewarded to the liquidity providers based on the amount of shares owned. The longer you stay in, the more you get.
Obviously low liquidity pairs are more risky in this system, but they usually offer higher rewards to supplement that beginning gap. Non mainstream coins are gonna be harder to provide liquidity for, especially if their price fluctuates heavy.
This is personally why I believe implementing a 3rd party coin exchange into Incognito would be so beneficial. Instead of having a few really big liquidity pools, we could balance it out, to coins with lower liquidity. That would mean instead of providing liquidity for one individual coin, your providing liquidity to the whole network. I believe this approach would be better. However, I wouldn’t expect Incognito’s liquidity to be balanced between all coins, just the major ones. Maybe it could be a percentage based system, 80% of the liquidity distributed between BTC, XMR, ETH, USDC/T, DAI. Then 20% of the liquidity distributed between less traded coins.