In a trade, investors or traders can encounter a difference between the executed and expected prices. And this is common in both cryptocurrency and traditional markets. Liquidity pools aim at eliminating the problems of illiquid markets by providing incentives to users and offering liquidity for some trading fees.
These pools are essential to the decentralised finance (DeFi) ecosystem. While the sellers and buyers of an asset provide liquidity in traditional finance, DeFi depends on liquidity pools to function.
In light of all this, let’s take a closer look at liquidity pools.
Definition Of Liquidity Pools In DeFi:
A liquidity pool is a collection of funds locked in a smart contract. These pools facilitate decentralised lending, trading, and other functions.
An example to understand the working of liquidity pools
A typical liquidity pool rewards users for staking their digital assets in a pool. The rewards can be in the form of cryptocurrency rewards. They can also be a part of the trading fees from exchanges where the pooling of the assets takes place.
Given below is an example of how this works. Consider yourself a trader who wishes to invest $20,000 in a BTC-USDT liquidity pool by using SushiSwap.
Step 1: Go to SushiSwap
Step 2: Find the BTC-USDT liquidity pool.
Step 3: Deposit a 50/50 split of USDT and BTC to the liquidity pool. Here, you will deposit $10,000 worth of BTC and $10,000 worth of USDT. You will receive BTC-USDT liquidity provider tokens (LPTs).
Step 4: Deposit the liquidity provider tokens to the BTC-USDT staking pool.
Then, you will get the SUSHI token as a reward after the lockup period, which you agreed to hold within a vault. This period can be fixed, like three months or one week.
The originally deposited BTC-USDT pair will earn a fraction of the fees collected from exchanges on that liquidity pool. Also, you will earn SUSHI tokens in exchange for staking the liquidity provider tokens.
Liquidity Pools: Use-cases
- Governance
Sometimes a considerable number of token votes are necessary to put forward a formal governance proposal. By pooling funds together, users can unite around a cause that they consider important for the DeFi protocols.
- Synthetic assets minting
Liquidity pools are also involved in generating synthetic assets on the blockchain. You can add collateral to a liquidity pool and link it to a trusted oracle, hence acquiring a synthetic token.
- Insurance sector
Liquidity pools support smart contract risk insurance, an emerging DeFi sector.
- Liquidity mining or yield farming
Users pool funds on automated yield generating platforms, creating yield or income. Liquidity mining helps cryptocurrency projects distribute new tokens to users who contributed to the liquidity pool.
Risks Of Liquidity Pools
- Temporary loss
There is also a possibility of temporary loss when offering liquidity to an AMM. Such losses lead to a loss in dollar value compared to HODLing (buy and hold strategy). It can be substantial sometimes and small at times.
- Access risks
You should also be aware of projects where the developers have the authority to change the regulations of the pool. Such developers can have privileged access within the smart contract code, like an admin key. This can enable them to do something malicious, like seize control of the funds in the pool.
- Smart contract-based risks
Ignoring risks that are based on smart contracts can lead to unmanageable losses. When you make contributions to a liquidity pool in terms of funds, the pool owns them. No intermediaries manage the assets, but the contract itself may act as the custodian.
Therefore, there is a possibility that you can lose funds completely if there is some flaw in the system, like a flash loan.
Popular Liquidity Pool Providers
Several decentralised platforms leverage AMMs to use liquid pools to allow digital assets to be traded permissionless and automated. There exist some popular platforms which centre their operations on liquidity pools. These are some of them:
- Curve: Based on the Ethereum network, a Curve is a decentralised liquidity pool for stablecoins offering low slippage, as stablecoins are not volatile.
- Balancer: A decentralised platform that offers a few pooling options like shared and private liquidity pools providing catered benefits for liquidity providers.
- Uniswap: This platform enables users to trade Ethereum for any other ERC-20 token without requiring a centralised service. An open-source exchange allows individuals to initiate an exchange pair on the network for free.
Closing Thoughts
DEXs faced cryptocurrency market liquidity issues in the early phases of decentralised finance while trying to model traditional market makers. Notably, liquidity pools helped address this issue by incentivising individuals to offer liquidity rather than having a buyer and seller match in an order book.
This gave a strong decentralised solution to liquidity in decentralised finance. Also, it proved to be instrumental in unlocking the DeFi sector growth. Even though liquidity pools may have been formed from necessity, their innovation offers a new way to offer decentralised liquidity algorithmically via incentivised, user-funded pools of asset pairs.
