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Published on: Aug 15, 2024
#Crypto 360
Liquidity pools are a unique concept in cryptocurrency and have no equivalent in the traditional financial sector.
Financial markets and all their activities are based on the concept of liquidity. If there was no way of easily accessing funds, financial operations would halt.
This idea is relevant to decentralised finance (DeFi), which is a blanket term for various financial services that operate on the blockchain. In DeFi, actions like lending, borrowing tokens, or trading tokens are performed through smart contracts, which are basically codes that operate transactions. Owners of DeFi protocols deposit their cryptocurrency into these contracts to enable others to use them—these are known as liquidity pools.
Liquidity pools are a unique concept in cryptocurrency and have no equivalent in the traditional financial sector. They are, however, essential in DeFi and ideal to investors searching for high-risk/high-return investments. What are liquidity pools and how do liquidity pools work?
A liquidity pool is a virtual wallet of cryptocurrencies held in a smart contract and used in trading activities. The DEXs do not use the abovementioned order, as they employ these pools to enable the traders to swap various assets without hassle.
The crypto liquidity pools encourage users to add their cryptocurrencies by offering incentives. Some of these incentives include commissions from the trading fees collected from the trading volume they bring and a share of tokens.
Image: How a liquidity pool looks like, by Moralis
When users deposit their tokens to a pool, they are typically given liquidity provider tokens. These tokens are the tokens that a user holds in the pool and can be employed to perform several activities across the DeFi space. To cash out the initial deposit and the fees earned, the provider must redeem and burn LP tokens.
Algorithms of Automated Market Maker (AMMs), the latest software development, help in the process to ensure that the fair market value of tokens can be kept in the liquidity pool. Since different pools may have slightly different algorithms, most DEXs use a ‘constant product formula’ to balance the ratios of tokens. This algorithm adapts the cost and the proportion that a given token holds when the market demand and supply fluctuate, a move that affects the prices.
At the initial phase of DeFi, DEXs used traditional banking models’ order books to link the buyers with the sellers. This method had several drawbacks. The order books were huge and needed a lot of computational power to match transactions, and the matching process was time-consuming. High transaction fees, or ‘gas fees’, disadvantaged smaller traders.
In 2017, the co-founders of the Bancor Network devised a new solution to the issue: a way for trades to be made using the liquidity pool of community-funded assets. This innovation greatly helped the fast development of the DeFi industry.
Simply put, liquidity pools are one of the principles that make the world of cryptocurrency function effectively, but their operation mechanism may not be obvious.
To grasp how crypto liquidity pools differ from traditional models, it's helpful to look at the foundational element of digital trading, mainly in the order book. An order book records all the orders open for a given market, including the buy and sell orders.
The system through which such orders are matched is called the matching engine. The order book, along with the matching engine, is the heart of any centralised exchange (CEX) operation. This system has proved very useful in implementing efficient trading activities, which has led to the evolution of several financial markets.
But that is how trading works in the decentralised finance (DeFi) environment, where trades are done directly on the blockchain with no intermediary party holding the funds. This setup has implications for order book usage because every interaction with an order book attracts gas fees, increasing trading costs.
Moreover, the function of market makers—traders who add liquidity to trading pairs—is becoming very expensive in this setting. Perhaps most importantly, the majority of blockchains, including Ethereum, cannot provide the necessary throughput to process billions of dollars' worth of trades daily. That’s where the necessity for liquidity pools comes in.
Image: How do liquidity pools work, by CP
Liquidity pools are essential for the cryptocurrency market, but their working mechanism might sometimes be confusing. These pools function in various ways, and lending pools are probably the most straightforward to explain.
In these pools, you can put, for instance, BTC or USDT into a lending protocol and receive a passive income as others borrow from that pool. This is controlled by smart contracts–self-executing digital contracts running on the blockchain–to make the whole process as efficient and infallible as possible.
Swap liquidity pools, which can be observed on decentralised exchanges (DEXs), are slightly more complicated. In essence, their main objective is to act as a peer-to-peer marketplace for the permissionless exchange of digital assets, eradicating the conventional exchange model. For example, if you have some BTC and want USDT tokens, you can exchange these assets through a liquidity pool.
Such liquidity pools work on an automated market maker (AMM). AMM is a particular kind of algorithm used to balance the assets in the pool. To do this, it provides the exchange rates of the cryptocurrencies in the pool depending on their market supply and demand. This system enables anyone with a crypto wallet to execute swaps with ease, hence fostering a smooth trading activity for all users.
While many people know about DEX liquidity pools, there are various other uses for these pools in the cryptocurrency space:
Borrowing and lending pool platforms involve users placing their assets to earn interest, where such funds are then accessible for use by other users in the ecosystem. Interest rates change in a decentralised manner, all depending on the number of people seeking the assets and the number of available assets to be given out as loans. Examples of such pools include the Aave and Compound platforms.
These are pools that are aimed at achieving the maximum possible yield from the assets that are either staked or lent. They usually delegate their funds into various pools on different protocols to maximise the returns, and sometimes, they can earn additional rewards such as the protocol’s native tokens as well as fees or interest.
Many companies use such pools to provide decentralised insurance services. Users invest money in these pools and are paid by the premiums received from those who want to buy insurance. If a claim is made, the pool rewards the claim.
Other prominent uses of crypto liquidity pools include:
• Market Making: They create a market by providing liquidity, getting paid for their services, and helping maintain its stability.
• Options and Derivatives: Liquidity pools facilitate the work of decentralised options and derivatives markets.
• Stablecoin Creation: Here are some you can use to create collateral and launch stablecoins within the DeFi sector.
• Cross-Chain Liquidity: Liquidity pools allow for the integration of different blockchain networks, making transactions easier across them.
• Token Launchpads: New tokens can be issued through crypto liquidity pools, and this way, they can get the initial demand.
• Arbitrage Opportunities: Liquidity pools are applied by traders to earn profit from the price disparities between two or more markets.
• Risk Management: Liquidity pools can serve as a kind of protection against risks associated with smart contracts.
• Governance and Voting: Those who provide liquidity are usually granted the right to vote on some issues within the pool.
• Cross-Asset Swaps: These pools enable traders to swap different assets even if the direct trading pairs are not listed on the exchange platform.
In trading, whether in the traditional or crypto market, a trader often has one price expectation while the trade is done at a different price. Liquidity pools are created to overcome the problems of markets with assets that cannot be sold and purchased easily (thin markets). Users are compensated for providing liquidity and for taking on the other side of trades for a share of the trading fees.
In decentralised exchanges such as Uniswap, trading with liquidity pools makes it easier to get the expected price and the price at which the trade is executed to be almost the same. The Automated Market Makers (AMMs) are put in place to ensure that trades are done without hitches by connecting the buyers and sellers of the crypto tokens in the DEX markets.
Yield farming is one of the ways through which a liquidity provider can receive rewards for contributing to a pool with LP tokens. This way, a liquidity provider can gain potentially high rewards for bearing more risk than usual by investing the funds in various trading pairs and can try to find pools that can give the highest value of trading fees and LP token rewards across varied platforms.
While liquidity pools bring many advantages, they also come with several risks and challenges:
Let me explain what a trader might experience as impermanent loss when providing liquidity to an AMM. Such a loss can be small or huge. In essence, it means a decline in the actual dollar worth when expressed against the retention of your asset. It happens when the prices of tokens added in the pool change when you add your tokens, and you can lose them entirely if the price moves drastically.
Liquidity pools work on the principle that their smart contracts are secure. However, as the above discussion shows, the disadvantages of these contracts can be catastrophic.
In the DeFi industry, things are advancing daily, which creates compliance risks that have the potential to influence the functionality and accessibility of crypto liquidity pools.
Swaps aren’t the only thing that liquidity pools are good for. Among those that provide swap liquidity, there are various categories of pools, and each type has a particular purpose or applies multiple approaches to the calculations that happen in the background.
For example, Uniswap V2 uses a constant product formula to balance the pool. Another popular DEX, Balancer, offers its users the possibility of changing the asset ratio in the pool to minimise the impermanent loss risk. The only difference is that instead of having one pool of voters evenly split at 50%, you may have an 80% pool of one voter and a 20% pool of the other.
These pools enable the exchange of stablecoins tied to $1. An example is the USDC/USDT pair, which can solve the concern of impermanent loss for those who supply liquidity.
These use a constant product model to ensure that the value of the assets in the pool remains constant.
These pools enable users to set the percentage of the assets to be traded to minimise the impermanent loss.
These pools use borrowed funds against the pool assets to offer more liquidity and higher returns.
These facilitate the lenders' earning of income to supply liquidity. Once that is done, borrowers can borrow from the pool using the collateral they have placed.
Liquidity pools are also known for enabling permissionless swaps, which means that anyone with a crypto wallet can swap tokens. Lending pools, another type of liquidity pool, are a way through which lenders can form a group of assets and get returns on the assets as a proportion of the pool as others borrow from it.
It is easy to start with liquidity pools, but they also carry risks. Therefore, I advise you to take some time to choose the right pools that will suit your income objectives and understand the risks, such as the impermanent loss. Selecting a pool from a liquid platform can be safer at first since the protocol is verified and audited.
Liquidity pools are digital wallets containing cryptocurrencies held in smart contracts. They can be used for important DeFi operations such as lending, borrowing, and trading.
Liquidity pools work by enabling users to deposit their tokens into a common pool, which enables the provision of trading services on DEXs and other DeFi platforms. AMMs help manage the balance sheet and price.
Liquidity pools are employed in market making, yield farming, lending and borrowing, options and derivatives trading, cross-chain liquidity, etc.
These risks include, among others, the risks of an impermanent loss, smart contract risks, and regulatory risks, which can directly influence the value, and the safety of the assets held in the pool.
Some of the ways users can earn rewards include yield farming, in which they get trading fees and token rewards by offering liquidity to DeFi platforms.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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