Decentralized finance (DeFi) is one of the biggest crypto-based ecosystems, comprising all decentralized applications that offer financial services to users.
Examples of such applications include decentralized exchanges (DEXs), lending protocols, yield farming projects, etc. And while these applications differ in their services, their operations revolve around the same fundamental concept – liquidity pools.
Simply put, a crypto liquidity pool is a digital pile of funds secured by a smart contract. In DeFi, these digital piles are vital to enabling any form of transaction. This article is curated to enlighten readers on what liquidity pools are, how they work, and what they are used for.
What is a Liquidity Pool?
A liquidity pool is a collection of cryptocurrencies locked in a smart contract. As the name implies, liquidity pools are used to readily provide liquidity, thus enabling faster transactions. They serve as the backbone of the DeFi space because they are vital for operations such as decentralized trading, lending, yield farming, and so on.
The most prominent use of liquidity pools is seen in a class of decentralized exchanges known as automated market makers (AMMs). Using liquidity pools, AMMs operate by allowing users to trade assets in an automated manner rather than in a traditional setting of buyers and sellers.
On these exchanges, certain users known as liquidity providers (LPs) supply an equal value of two tokens to a pool, thereby creating a market where both tokens can be traded against each other. In return for depositing their tokens, LPs are rewarded trading fees and incentives proportional to their share in a given pool.
Common examples of Ethereum-based exchanges that use liquidity pools are SushiSwap, Uniswap, and Curve. These protocols can only be used for trading ERC-20 tokens. On the BNB Smart Chain, PancakeSwap and BakerySwap are popular exchanges with liquidity pools for trading BEP-20 tokens.
How do Liquidity Pools Work?
Crypto liquidity pools are created by depositing the equivalent value of two tokens into a smart contract. On decentralized exchanges, these pools function as a mechanism that allows for on-chain trading without the need for a direct counterparty.
When you trade assets on an AMM, there is no other trader on the other end, as is common with most peer-to-peer exchanges which use an order book. Rather, you are trading against the liquidity present in a given pool. Simply put, for a buyer to purchase a specific token, there is no need for the actual seller, only sufficient liquidity of the said token in that pool.
With this method of operation, liquidity pools have revolutionized on-chain trading, allowing users to execute speedy transactions with the freedom to get in and out of trading positions on any market pair. That said, the trading activities in liquidity pools are usually regulated by an algorithm respective to each AMM. This algorithm also decides the price of each asset in relation to the other asset in the pool at each given time.
Liquidity pools are equipped with incentives that encourage the participation of liquidity providers. When you supply tokens into any liquidity pool, you earn trading fees and other rewards from the DEX. Moreover, you are given liquidity pool tokens (sometimes known as liquidity provider tokens) which can be used to withdraw your deposited liquidity.
Liquidity Pools vs Order Books
Orders books are foundational components of the electronic trading system. They are electronic lists that contain buy and sell orders for a specific market. Orders books are usually operated with a matching engine forming a trading model that enables the efficient exchange of several assets, including stocks, derivatives, and sometimes cryptocurrencies.
Order books are majorly used in traditional finance, such as centralized exchanges, with little application in decentralized trading. This is because the DeFi space is populated mainly with AMMs, which bank on the use of liquidity pools.
This DeFi dominance of liquidity pools is majorly associated with the lack of blockchain infrastructure to support the daily trading volume of a typical order-book exchange which usually runs into billions of dollars. Many blockchains, including Ethereum – which is home to several thousand assets in the crypto space – are currently not equipped to process such a large volume of daily transactions.
In addition, the operation of liquidity pools is less costly than that of order books. Each interaction with an on-chain order book is accompanied by payment of gas fees. Thus, providing liquidity or executing a trade on a blockchain-based order-book exchange is usually expensive.
What are Crypto Liquidity Pools Used For?
As discussed earlier, the most popular application of liquidity pools relates to AMMs, which serve as the basis for the seamless decentralized trading of crypto assets. That said, liquidity pools are also used for a variety of operations in the blockchain industry.
Yield Farming
Yield farming allows investors to deposit their assets into pools for a period of time in order to earn returns. Yield farming can be in the form of staking or lending your tokens to DeFi platforms that require liquidity to operate. Common yield farming protocols include Aave, Compound, Instadapp, etc.
Liquidity Mining
Another application of liquidity pools is liquidity mining. Similar to yield farming, liquidity mining requires investors to lock their funds in a liquidity pool in exchange for interest. However, liquidity miners are usually paid in the native tokens of the mining platform rather than their primary investment assets.
Governance
On-chain governance is another profound application of liquidity pools. On certain protocols, delegators with a higher number of governance tokens can exhibit more influence on the network operations. In such instances, investors can pool their native tokens together to support proposals they collectively believe can develop the network.
Asides from the points listed above, other use cases of liquidity pools include on-chain insurance, blockchain gaming, synthetic assets, etc.
Pros of Liquidity Pools
The invention of liquidity pools introduced some intriguing benefits to the DeFi space. Some of these advantages include:
- Rewards: Liquidity Pools allow investors to provide liquidity and earn rewards in the form of interest, governance tokens, transaction fees, and so on.
- Real-time Trading: Using liquidity pools, decentralized exchanges are able to execute trades at real-time market prices.
- Transparency: Liquidity pools are based on smart contracts and blockchain programs with codes that are publicly verifiable by everyone.
Cons of Liquidity Pools
While liquidity pools provide some interesting benefits to investors, it is worth noting that this trading mechanism still presents some limitations. Some of these disadvantages include:
- Impermanent Loss: This happens when the value of your asset in a liquidity pool experiences an unrealized loss as compared to the real-time value of the asset.
- Slippage: If not enough liquidity is provided to a pool it can become unstable. Transactions with a large enough volume will cause a mass shift in pricing when swapping tokens causes an executed price different from the one expected.
- Hacking Exploits: Smart contract vulnerabilities can be exploited by hackers, resulting in losses for liquidity providers.
- Scam Projects: The lack of regulation in the DeFi space means there are fraudulent projects and exit scams. Being a liquidity provider to such ventures results in asset loss.
FAQs
What is the point of liquidity pools?
A liquidity pool is designed to allow traders to execute their buy and sell orders at any time of the day and at their desired price without the need for a direct counterparty.
What is a good liquidity pool?
A good liquidity pool is one with a verified smart contract code. It should also have a large amount of liquidity and high trading volume, coupled with protection mechanisms against risks such as impermanent losses.
When is it a good time to exit a liquidity pool?
It is best to withdraw your funds from a liquidity pool when the price of the assets in the pool becomes volatile. This is because the risk of impermanent losses increases with a higher volatility level.
Wrap Up
Crypto liquidity pools are core pillars of the DeFi ecosystem, as almost all DeFi protocols rely on these digital pools for efficient operation. And with the continuous expansion of the DeFi space, the use of liquidity pools is likely to receive more attention, which could lead to the development of several novel use cases.
