Liquidity pools have emerged as a vital component in revolutionizing the way liquidity is provided and utilized.
In this guide, we will explore the concept of liquidity pools, their role in DeFi protocols, and the benefits they offer to participants.
Decentralized finance (DeFi) is on its way to strongly competing with centralized finance (CeFi).
DeFi transfers the power from the financial middlemen to regular people by providing exposure to global markets and alternatives to the existing banking options or local currency.
One of the crucial building blocks of the DeFi ecosystem is the ‘Liquidity Pool.’
Traditional Markets and Inefficiencies
Traditional financial markets (like the Stock market) use the ‘Order Book Model.’
Buyers and sellers electronically enter the order containing the quantity and price of the stock they want to buy and sell. When the buy and sell order matches, then a trade is completed.
Centralized crypto exchanges (like Coinbase and Kraken) also use order books to match buyers and sellers for each cryptocurrency trading pair.
However, this model is not without challenges.
- Usually, the buyers look for the lowest price, and the sellers look for the highest price. As a result, they might not always agree on a price all the time. They need to set a price that others are willing to trade, or they might get stuck with assets they can’t sell.
- Also, in case of low liquidity, there is the problem of slippage. It is the difference between the expected price of a trade and the executed price. The lower the liquidity, more the slippage, creating a massive gap between the original market order price and the traded price.
Liquidity Pools: Work Mechanism
The financial world thrives on liquidity, and DeFi is no different.
Liquidity pools play a vital role in creating a ‘liquid’ DeFi system. It is a pool of crowdsourced funds locked into a smart contract (i.e., Computer codes) to provide liquidity for decentralized exchanges (DEX), lending and borrowing protocols, and other applications. It allows crypto traders and investors to access funds in the DeFi markets.
There are three key components that make up the liquidity pool — Liquidity Providers (LPs), Liquidity Provider Tokens (LPTs), and Automated Market Makers (AMMs).
1. Liquidity Providers (LPs)
LPs are individuals who use their crypto assets to provide liquidity to a pool that enables the operation of the underlying DeFi protocol. The most common assets deposited in liquidity pools include ETH, BNB, USDT, USDC, and DAI.
2. Liquidity Provider Tokens (LPTs)
When LPs deposit funds in a pool, they receive a liquidity provider token (LPT) representing their contribution. It can be later utilized to earn financial incentives.
3. Automated Market Makers (AMMs)
AMMs are algorithms that help the liquidity pool maintain market value for the crypto assets based on executed trades within the pool. It uses a mathematical formula to set the prices, maintaining high liquidity.
The funds provided to the pool by LPs enable liquidity for handling transactions. Hence, unlike traditional markets, users transact against the liquidity in a smart contract rather than with other users.
The AMM ensures that the pool preserves liquidity by increasing the price of an asset as demand increases. Constant Product Market Maker (CPMM) is the most common of many variants of Automated Market Makers.
For example,
- Trading pools (like SushiSwap and Uniswap) use CPMM, where liquidity providers deposit two cryptos of equal proportion to the pool (like ETH and BAT).
- Whereas, Balancer can hold up to eight assets. The algorithm to maintain a similar ratio among eight assets is complicated.
Incentive Structure
In the Order Book model, liquidity is provided only by buyers and sellers of an asset.
On the other hand, within DeFi, anyone can become an LP by depositing two or more cryptocurrencies into a pool, typically of equal proportion. This provides a market for performing trading activities for that crypto pair.
As an incentive, LPs receive LPTs and rewards (i.e., trading fees) proportional to their financial contribution from the protocol they pool tokens.
Apart from the trading fees, LPs can earn protocol tokens as an additional incentive by staking the LPTs. This process is called Yield Farming or Liquidity Mining.
Suppose a trader deposits $200 in a BNB-BUSD liquidity pool using PancakeSwap. The steps would be as follows,
Step 1: Go to PancakeSwap.
Step 2: Find the BNB-BUSD liquidity pool.
Step 3: Deposit a 50/50 split of BNB and BUSD to the BNB-BUSD liquidity pool. In this case, the trader would deposit $100 of BNB and $100 of BUSD.
Step 4: Receive BNB-BUSD liquidity provider tokens.
Step 5: Deposit LPTs to the BNB-BUSD staking pool.
Step 6: Get the CAKE token as a reward after the lockup period, which the trader agreed to hold within a vault. It can be a fixed time, like one week or three months.
Applications of Liquidity Pools
Decentralized trading and yield farming are the most prevalent use cases of liquidity pools.
However, there are other applications for which liquidity pools are utilized.
1. Decentralized Lending
Decentralized lending is another famous use case of liquidity pools. Lending pools allow lenders to deposit crypto to earn interest payments and the respective protocol token so borrowers can borrow.
2. Cross-Platform Collaboration
Apart from the respective platform, LPTs can also be staked or used to provide liquidity on other platforms. This offers more liquidity for the DeFi ecosystem and enables LPs to leverage their crypto assets to increase potential returns.
3. Others
Other use cases include governance, minting synthetic assets, blockchain gaming, and tranching.
With rapid innovation in the DeFi space, liquidity pools are set to have more applications in the future.
Benefits of Liquidity Pool
Let’s start with some of the critical benefits of liquidity pools.
1. Highly Efficient
Liquidity pools remove the inefficiencies of the Order Book Model by ensuring constant liquidity. Also, as users engage with the smart contract, they can transact in a trustless manner.
2. Investment Opportunities
It provide a lucrative opportunity for the participants with multiple layers of earning opportunities. The best part is that anyone can become a liquidity provider.
3. Governance
Also, LPs can participate in the decision-making of the protocol as they provide liquidity by earning governance tokens and using them to vote.
Risks of Liquidity Pool
Although these are promising, they also come with certain risks.
1. Impermanent Loss (IL)
IL occurs when the ratio of two assets in a pool becomes uneven due to a sharp price increase in one of the assets versus the other.
The loss can become permanent if an LP withdraws its funds from the pool before a price recovery. However, liquidity providers can cover impermanent losses with transaction fees depending on the deposit duration.
2. Scope for Centralization
Liquidity pools with centralized authority encourage malicious behavior as a developer can decide to take control of the liquidity pool.
3. Technical Bugs
Code errors expose some smart contracts to hacks. For example. hackers stole $11 million of users’ funds from Yearn Finance by exploiting the bugs in code.
6 major Examples of Liquidity Pools
Out of the hundreds of DeFi protocols offering liquidity pools, only a handful of them have emerged as the best liquidity pools. Following is the list of those
- 1.Aave
- 2.Uniswap
- 3.PancakeSwap
- 4.SushiSwap
- 5.Balancer
- 6.Curve Finance
Conclusion
Liquidity pools play a pivotal role in the DeFi space, offering an efficient way for users to provide and access liquidity. They facilitate seamless trading, enable yield farming opportunities, and promote market efficiency.
By understanding the mechanisms, risks, and strategies associated with liquidity pools, participants can make informed decisions and leverage these pools to their advantage.
As the DeFi ecosystem evolves, these are expected to remain a critical element, driving innovation and transforming the traditional financial landscape toward a more inclusive and decentralized future.
