What are liquidity pools and how do they work?

Blockchain / 6 Min Read
Axi Team / 30 Sep 2021

Decentralised liquidity pools have become an integral part of the global crypto markets, enabling traders and investors across the globe to access market liquidity with the click of a button.

In this guide, you will learn everything you need to know about liquidity pools and how to use them. Jump ahead through the sections below to get the information you need:

What are liquidity pools?

In a nutshell, a liquidity pool allows crypto traders and investors to gain access to market liquidity in the decentralised finance (DeFi) markets. 

More specifically, liquidity pools are a pool of funds placed into a smart contract to provide liquidity for decentralised exchanges (DEX), lending and borrowing protocols, and other DeFi applications.

You can think of a liquidity pool as a decentralised alternative to an order book or matching engine powered by smart contracts.

What is a liquidity provider?

Liquidity providers (LPs) are individuals or professional market participants who use their crypto assets to provide liquidity to a liquidity pool to enable the underlying DeFi protocol to function. 

Decentralised trading pools open up the financial market for any individual to be a liquidity provider through the use of automated market makers (AMMs).

In a decentralised exchange, for example, liquidity providers fund a smart contract with two or more cryptocurrencies, typically of equal proportion. This provides a market for facilitating trading activities for that crypto pair.

Liquidity providers are incentivised to provide liquidity as they are rewarded with a percentage of the transaction fees of the exchange. The rewards they receive are in proportion to the share of liquidity they provide in the pool.

How do liquidity pools work?

In the traditional financial markets, market liquidity is found in the order book of a specific asset or currency pair. There, buyers and sellers are matched once two parties can agree on a price for the amount they want to trade to fill an order. 

Centralised crypto exchanges, like Coinbase, Binance and Kraken, also use order books to match buyers and sellers for each cryptocurrency trading pair. 

To act as a market maker (i.e. someone who makes money by providing liquidity to a market by providing bids and offers to other traders), a substantial amount of capital is typically required both in the traditional and in the crypto capital markets. 

In the decentralised finance (DeFi) market, however, anyone can become a liquidity provider by depositing into a crypto liquidity pool and receive rewards in the form of trading fees proportional to their financial contribution to the liquidity pool.

The funds deposited in the smart contracts by liquidity providers enable constant liquidity for any transaction. In essence, people transact against the liquidity in a smart contract rather than market makers or other users. 

Liquidity pools use an algorithm that is responsible for determining the pricing of assets based on trades occurring in the pool. The algorithm ensures the pool maintains liquidity by increasing the price of an asset as the demand increases.

Diagram of Uniswap liquidity pool

Source: Uniswap

Trading pools, like Uniswap and SushiSwap, use a constant market maker algorithm where liquidity providers deposit two currencies of equal proportion to the pool. For example, ETH and USDC. 

In addition to receiving a share of a pool’s trading fees, LPs can also earn protocol tokens as an incentive for contributing liquidity to the trading platform by staking co-called liquidity provider tokens (LP tokens).

What are liquidity provider tokens?

When liquidity providers deposit funds in a pool, they receive a liquidity provider token (LPT) that represents their share of the pool.

Liquidity provider tokens (LPTs) are used to determine the amount of funds LPs contributed in a pool and the share of transaction fees they receive for providing liquidity. This enables LPs to have control over their assets while they are in the pool.

Considering LPTs have the same properties as other tokens of the blockchain they run on, they can be staked, traded or transferred to other protocols of the same blockchain.

For example, a BNB-BUSD LPT can be staked on PancakeSwap to earn the trading platform’s protocol token, CAKE.

Recommended reading: What is tokenomics? Understanding the token economy

Why do we need liquidity pools?

DeFi protocols all operate using smart contracts, and the execution of smart contracts costs a gas fee (i.e., a blockchain transaction fee). Bringing traditional order books into decentralised exchanges results in slow performance and high transaction costs, as seen in the early days of decentralised trading on the Ethereum blockchain back in 2017.

Considering most DeFi protocols run on Ethereum, which processes only 13 -15 transactions per second, it will take a very long time to fulfill orders using a traditional order book system. Also, gas fees are quite expensive in the Ethereum network, which would substantially eat into market makers’ returns. Hence, the need for another liquidity provision method gave rise to the use of liquidity pools.

The automated market maker protocol originally proposed by Ethereum founder Vitalik Buterin in liquidity pools replaces the order book with mathematical formulas for pricing assets and allowing for trade execution, enabling anyone to trade in a decentralised, trustless and transparent way. Also, the ability for anyone to provide liquidity ensures that the open, borderless, and inclusive crypto ethos is maintained.

What are liquidity pools used for?

Liquidity pools are the fuel behind most DeFi protocols, with over $83 billion in crypto locked in these smart contracts. 

The main use case for liquidity pools is decentralised trading, which has been the focus of most of this article. However, there are other protocols where liquidity pools are also utilised.

Decentralised lending is another popular use case for liquidity pools. Decentralised lending pools enable lenders to deposit crypto for borrowers to borrow in exchange for interest payments and (typically also) a protocol token.

Yield farming or liquidity mining is another popular use case for liquidity pools. Liquidity providers can stake their liquidity provider tokens (LPTs) to earn additional yield as liquidity providers are typically paid out in the platform’s native token.

Liquidity provider tokens can also be staked or used to provide liquidity on other platforms. This provides more overall liquidity for the DeFi ecosystem and enables LPs to leverage their crypto assets to increase potential returns. 

Other eye-catching uses of liquidity pools include minting synthetic assets, tranching, and governance. With the increased rate of innovations in the crypto space, liquidity pools are poised to have more use cases as time goes by.

How to join a liquidity pool?

The process for accessing liquidity pools only varies slightly from platform to platform. While some are more technical and require more expertise, others are very user-friendly and gamified to make the experience as easy as possible. 

To join a liquidity pool, you will have to create an account with the platform of your choice and connect with a smart contract-enabled crypto wallet, such as Metamask. Next, you'll have to choose a cryptocurrency pair and the liquidity pool to deposit your crypto asset into.

Then, you have to make sure you have enough of the two assets you want to deposit. Finally, you deposit the two assets to receive your LP tokens.

And it’s as simple as that!

What risks are involved with liquidity pools?

Although liquidity pools provide an incredibly valuable role in the DeFi market, they also come with certain risks. These risks are explored below:

Impermanent loss

When the ratio of two assets held in a liquidity pool becomes uneven due to a sharp price increase in one of the assets versus the other, LPs can experience what is referred to as impermanent loss as they lose out on the gains on one of the held assets versus simply buying and holding them.

The loss can become permanent if a liquidity provider withdraws their funds from the pool before a price recovery. However, liquidity providers can cover up impermanent losses with transaction fees depending on the fluctuation size or the duration of their deposit.

Smart contract bugs 

Another risk of liquidity pools is the smart contracts governing them. Some smart contracts are susceptible to hacks due to errors in their codes. An example is the Yearn Finance hack of February 2021, where hackers stole $11 million worth of users’ funds.

Centralised governance

Liquidity pools where governance is overly centralised gives room for malicious behaviour as a developer can decide to take control of the funds in the pool. Therefore, it’s important to choose wisely where to deposit funds in a pool.

PRO TIP: To avoid getting burnt while providing liquidity in a pool, you must carefully research the protocol you plan to deposit funds into, ensure that you fully understand what you are depositing crypto into, and understand all the risks involved.

What are the benefits of liquidity pools?

While taking part in liquidity pools can be somewhat challenging at first for crypto newcomers, the benefits of these new financial protocols suggest that liquidity pools are here to stay. 

Let's look at some of these benefits.

  • Liquidity pools ensure there is enough liquidity for DeFi protocols, especially decentralised exchanges and lending platforms.
  • Provision of liquidity is not restricted only to well-heeled market makers. Anyone can provide liquidity in a pool.
  • Liquidity providers have access to multiple layers of earning opportunities by using their liquidity providers tokens on other DeFi protocols.
  • Liquidity providers can participate in the decision making of a protocol they provide liquidity for by earning governance tokens and using them to vote.
  • Liquidity pools enable traders to transact in a trustless manner.

Examples of liquidity pools

There are hundreds of liquidity pools in the decentralised trading space, but a handful of trading platforms have emerged as the go-to options for traders and investors looking for decentralized crypto liquidity. They include: 

  • Uniswap
  • Balancer
  • Curve Finance
  • PancakeSwap
  • Bancor
  • Convexity Protocol
  • Kyber Network 
  • SushiSwap

Uniswap add liquidity pool menu

 

Liquidity pools exist for a wide range of assets because they can be created by users themselves. The only restriction is that the tradable tokens must be available on the chain that the liquidity pool provider operates.

For example, on Uniswap and SushiSwap, you can only trade Ethereum-based ERC20 tokens, while PancakeSwap is limited to Binance Smart Chain’s BEP20 tokens. 

The most popular assets you can find in liquidity pools include ETH, BNB, and stablecoins like DAI, USDT, and USDC. Even popular “meme coins” like SafeMoon can be traded or deposited in liquidity pools.

What is the difference between staking and liquidity provision?

Traditionally, staking refers to the process of locking up your crypto asset in a blockchain in order to keep the network secure and earn rewards from transaction fees. With the dawn of DeFi, the definition of staking has broadened to contain any form of depositing of a crypto asset to earn a financial reward. For example, today, you can even stake an NFT to earn tokens. 

Liquidity provision refers to depositing one or more assets into a liquidity pool to earn trading fees or lending interest. While the concept is not that different from staking, the mechanics and risks involved are different. 

Moreover, liquidity providers can use their liquidity pool tokens (LPTs) and stake them to earn additional rewards on top of fees or interest, which is where staking comes into play for liquidity providers. 

Liquidity pools provide an exciting new potential earnings opportunity for crypto-savvy investors entering the fast-growing DeFi markets.

 

We hope that this article will help you on your journey to buying, owning, and trading cryptocurrencies. Start trading cryptocurrency CFDs with Axi today.

 

 

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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