Liquidity is a fundamental part of both the crypto and financial markets. It is the manner in which assets are converted to cash quickly and efficiently, avoiding drastic price swings. If an asset is illiquid, it takes a long time before it is converted to cash. You could also face slippage, which is the difference in the price you wanted to sell an asset for vs. the price it actually sold for.
Liquidity pools play a large part in creating a liquid decentralized finance (DeFi) system.
Imagine waiting to order inside a fast-food restaurant. Liquidity is comparable to having lots of cashiers. That would speed up orders and transactions, making customers happy. On the other hand, illiquidity is comparable to having only one cashier with a long line of customers. That would lead to slower orders and slower transactions, creating unhappy customers.
In traditional finance, liquidity is provided by buyers and sellers of an asset. In contrast, DeFi relies on liquidity pools to function. A decentralized exchange (DEX) without liquidity is equivalent to a plant without water. It won’t survive. Liquidity pools provide a lifeline to DEXs.
What is a liquidity pool?
A liquidity pool is a digital pile of cryptocurrency locked in a smart contract. This results in creating liquidity for faster transactions.
A major component of a liquidity pool are automated market makers (AMMs). An AMM is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.
In other words, users of an AMM platform supply liquidity pools with tokens, and the price of the tokens in the pool is determined by a mathematical formula of the AMM itself.
Liquidity pools are also essential for yield farming and blockchain-based online games.
Liquidity pools are designed to incentivize users of different crypto platforms, called liquidity providers (LPs). After a certain amount of time, LPs are rewarded with a fraction of fees and incentives, equivalent to the amount of liquidity they supplied, called liquidity provider tokens (LPTs). LP tokens can then be used in different ways on a DeFi network.
What is the purpose of a liquidity pool?
In a trade, traders or investors can encounter a difference between the expected price and the executed price. That is common in both traditional and crypto markets. The liquidity pool aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.
Trades with liquidity pool programs like Uniswap don't require matching the expected price and the executed price. AMMs, which are programmed to facilitate trades efficiently by eliminating the gap between the buyers and sellers of crypto tokens, make trades on DEX markets easy and reliable.
What are the incentives for liquidity pool providers/depositors?
There are multiple ways for a liquidity provider to earn rewards for providing liquidity with LP tokens, including yield farming.
This allows a liquidity provider to collect high returns for a slightly higher risk by distributing their funds to trading pairs and incentivizing pools with the highest trading fee and LP token payouts across other platforms.
How does a liquidity pool work?
As mentioned above, a typical liquidity pool motivates and rewards its users for staking their digital assets in a pool. Rewards can come in the form of crypto rewards or a fraction of trading fees from exchanges where they pool their assets in.
Here is an example of how that works, with a trader investing $20,000 in a BTC-USDT liquidity pool using SushiSwap.
The steps would be as follows:
- Go to SushiSwap.
- Find the BTC-USDT liquidity pool.
- Deposit a 50/50 split of BTC and USDT to the BTC-USDT liquidity pool. In this case, you would deposit $10,000 worth of USDT and $10,000 worth of BTC.
- Receive BTC-USDT liquidity provider tokens.
- Deposit LPTs to the BTC-USDT staking pool.
- Get the SUSHI token as a reward after the lockup period that you agreed to hold within a vault. It can be a fixed time like one week or three months.
The BTC-USDT pair that was originally deposited would be earning a portion of the fees collected from exchanges on that liquidity pool. In addition, you would be earning SUSHI tokens in exchange for staking your LPTs.
Popular liquidity pool providers
Many decentralized platforms leverage automated market makers to use liquid pools for permitting digital assets to be traded in an automated and permissionless way. In fact, there are popular platforms that center their operations on liquidity pools.
- Uniswap – This platform allows users to trade ETH for any other ERC-20 token without needing a centralized service. It is an open-source exchange that lets anyone start an exchange pair on the network for free.
- Curve – A decentralized liquidity pool for stablecoins based on the Ethereum network. It provides reduced slippage because stablecoins aren't volatile.
- Balancer – A decentralized platform providing a few pooling options such as private and shared liquidity pools offering catered benefits for its liquidity providers.
Pros and cons of liquidity pools
- Simplifies DEX trading by performing transactions at real-time market prices.
- Allows people to provide liquidity and receive rewards, interest or an annual percentage yield on their crypto.
- Uses publicly viewable smart contracts to keep security audit information transparent.
- The pool of funds is under the control of a small group, which is against the concept of decentralization.
- Risk of hacking exploits because of poor security protocols, causing losses for liquidity providers.
- Risk of frauds such as rug pulls and exit scams.
- Exposure to impermanent loss. This happens when the price of your assets locked up in a liquidity pool changes and creates an unrealized loss, versus if you had simply held the assets in your wallet.
Read More: How to Stay Safe in DeFi
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