In order to provide fast and fair trades, Decentralized Exchanges (DEXs) utilize crowdsourced funds of tokens locked in a smart contract - also known as ‘liquidity pools’. The term is easy to come across, as liquidity pools are a cardinal part of the DeFi sector. Let’s first discuss the basics behind liquidity pools technology and then talk about how liquidity affects the crypto market.
N.B. Learn more about DeFi via GetBlock’s Guide
What are liquidity pools?
Liquidity pools hold a significant place in facilitating digital asset conversion with maximum speed and convenience. A liquidity pool is, essentially, a tool that allows Liquidity Providers (LP) to lock their assets in a smart contract and, in return, make a profit off of various fees. These incentives are also known as Liquidity Provider Tokens (LPT). Anyone can become a Liquidity Provider. LPs act as middlemen in performing trades. The earnings they make are then spread out proportionally among all LPs in the pool.
All in all, the more locked tokens a pool has, the better liquidity it facilitates, leading to easier and more robust trades.
As mentioned above, liquidity pools are essential when it comes to maintaining the proper operational state of the decentralized finance ecosystem, namely decentralized exchanges (DEXs). Before liquidity pools were introduced, DEXs used to be extremely complicated and inconvenient. As numerous cases show, little liquidity is likely to result in higher volatility, the phenomenon known as slippage. The term ‘slippage’ is used to describe the difference between the initial and the final token prices. Liquidity pools fix the problem by facilitating efficient decentralized trades with the help of several technological components.
How do liquidity pools work?
Automated market makers
One of the main elements of liquidity pool technology is an automated market maker (AMM). AMM is an underlying protocol that creates the automated reality for the efficient trading of digital assets with no counterparty or middlemen involved (unlike the “traditional” peer-to-peer trading).
AMMs are programmed to execute trades against the liquidity in the pool. Their goal is to supply pools with sufficient liquidity for the buyer to not need the seller. Thanks to AMMs, DEXs have become way more trust-worthy and the huge polarity between the expected and the executed prices as well as all the unconventional problems which come with it have been eliminated to the current maximum ability.
What’s more, liquidity pools are closely associated with yield farming. Yield farming is another DeFi neologism that is used to describe the process of maximizing returns from DEXs trades by lending or staking cryptocurrencies. For many, yield farming is a way of earning passive income from contributing to liquidity pools.
Yield farming came to prominence during the 2020 DeFi summer. The process is known to be highly risky. However, that does not stop yield farmers from profiting off of incentives, which are later calculated as an annual percentage yield (APY). The fewer investors are involved in a pool, the more returns they can get.
N.B. Read more on SushiSwap - the so-called yield farming platform here.
Liquidity pool examples
Uniswap is arguably one of the top leading DEXs on the market right now. It supports ERC-20 tokens and contract trades in a 1:1 ratio. Uniswap liquidity pool is part of the decentralized exchange. The popularity of Uniswap can be proven by its high trading volumes. The liquidity pool also allows users to launch new trading pairs for free.
As of 2022, Bancor is a popular Ethereum-based liquidity pool, which seeks to eliminate the problem of volatility. Bancor utilizes algorithmic market-making methods alongside smart contract support.
Balancer is a flexible crypto liquidity pool running on Ethereum. It also acts as a noncustodial portfolio manager and price sensor. Balancer’s distinguishing feature is its ability to support multiple pooling methods, e.g. private, shared, and smart.
Next up is Curve Finance - another Ethereum-based liquidity pool, which offers stablecoin trading. Due to the non-volatile nature of stablecoins, the possibility of slippage is highly unlikely.
Source: Curve Finance
Last but definitely not least, Kyber Network. Being one of the best Ethereum-based liquidity pools as of this year, it offers an easy-to-use interface tailored to meet the user’s requirements. Kyber utilizes dApps to provide sufficient liquidity to pools.
Final thoughts: liquidity pools pros and cons
Liquidity pools have drastically transformed the decentralized finance sector by offering simplified and convenient digital asset transactions and making it possible for users to generate a passive income via the new technology.
The emergence of liquidity pools was an unquestionable necessity, which has massively contributed to raising awareness of DeFi among investors. However, the technology is yet to be improved. For instance, the concept of Liquidity Providers may potentially undermine the decentralized approach. There could also be a risk of fraud and hacking exploits.
Nevertheless, the liquidity pool is a powerful tool and the underlying technology for many dApps used by millions of crypto enthusiasts and professionals on a daily basis, therefore there’s a high likelihood the technology will continue to grow and improve.