What are liquidity pools?
Liquidity pools allow users to buy and sell cryptocurrency on decentralised exchanges and other DeFi platforms without the need for centralised market makers.
Summary
A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate transactions between assets on a decentralized exchange (DEX). Instead of traditional buyers and sellers markets, many decentralized finance (DeFi) platforms use automated market makers (AMMs), which allow digital assets to be traded automatically using liquidity pools.
CONTENTS
- The role of crypto liquidity pools in DeFi
- Why are crypto liquidity pools important?
- How do crypto liquidity pools work?
- Yield farming and liquidity pools
- The real value of crypto liquidity pools
The role of crypto liquidity pools in DeFi
Cryptocurrency pools play an important role in the decentralised finance (DeFi) ecosystem, especially when it comes to decentralized exchanges (DEX).
Liquidity pools are a mechanism by which users can pool their assets into DEX smart contracts to provide traders with asset liquidity to exchange between currencies.
Liquidity pools provide the much-needed liquidity, speed and convenience to the DeFi ecosystem.
Before automated market makers (AMMs) came into play, cryptocurrency market liquidity was a problem for DEX on Ethereum. At the time, DEX was a new technology with a complex interface, and the number of buyers and sellers was small, therefore it was hard to find enough people willing to trade on a regular basis. AMMs solve this problem of limited liquidity by creating liquidity pools and offering liquidity providers an incentive to supply those pools with assets, all without the need for third-party intermediaries. The more assets in a pool and the more liquidity it has, the easier it becomes to trade on decentralised exchanges.
Why are crypto liquidity pools important?
Any experienced trader in traditional or cryptocurrency markets can tell you of the potential disadvantages of entering a market with low liquidity. Whether it’s low-cap cryptocurrency or penny stock, slippage will be an issue when trying to enter or exit any transaction.
Slippage is the difference between the expected transaction price and the price at which it is executed. Slippage is most common during periods of high volatility and can also occur when a large order is executed, but there is not enough volume at the selected price to maintain the bid-ask spread.
Such order price, which is used during periods of high volatility or low volume in the traditional order book model, is determined by the bid-ask spread of the order book for that trading pair. This means that the slippage is the midpoint between what sellers are willing to sell the asset for and the price at which buyers are willing to buy it. However, low liquidity can lead to more slippage, and the executed trade price can be much higher than the original market price of the order, depending on the bid-ask spread for the asset at any given time.
Liquidity pools are designed to solve the problem of illiquid markets by encouraging users themselves to provide cryptocurrency for a share of the trading fees. Trading using liquidity pool protocols such as Bancor or Uniswap does not require buyer and seller matching. This means that users can simply exchange their tokens and assets using liquidity provided by users and executed via smart contracts.
How do crypto liquidity pools work?
Crypto liquidity pools should be designed to encourage crypto liquidity providers to place their assets in the pool.
This is why most liquidity providers earn trading fees and cryptocurrency rewards on the exchanges on which they pool tokens.
When a user provides liquidity to a pool, the provider is often rewarded with Liquidity Provider (LP) tokens. LP tokens can themselves be valuable assets and can be used in the DeFi ecosystem for a variety of purposes.
Typically, the cryptocurrency provider receives LP tokens in proportion to the amount of liquidity they provide to the pool. When the pool facilitates trading, the fractional commission is distributed proportionally to the LP token holders. In order for the liquidity provider to recover the liquidity they contributed (in addition to the accrued commission on their share), their LP tokens must be destroyed.
Liquidity pools maintain a fair market value for the tokens they store through AMM algorithms that maintain the price of the tokens relative to each other in any given pool. Liquidity pools may use slightly different algorithms in different protocols.
For example: Uniswap liquidity pools use a constant product formula to maintain price ratios, and many DEX platforms use a similar model. This algorithm helps ensure that the pool continuously provides liquidity to the cryptocurrency market by managing the value and ratio of the relevant tokens as the quantity required increases.
Yield farming and liquidity pools
To make trading more convenient, various protocols offer users even more incentives to provide liquidity by providing more tokens to certain “incentivised” pools. Participating in these incentivised liquidity pools as a provider to receive the maximum number of LP tokens is called liquidity mining. Liquidity mining is how liquidity providers on a cryptocurrency exchange can optimise the profit of their LP tokens on a particular market or platform.
There are many different DeFi markets, platforms, and incentivised pools that allow you to receive rewards for providing and mining liquidity with LP tokens.
So, how does a cryptocurrency provider choose where to place their funds? This is where Yield Farming comes into play.
Yield farming is the practice of placing or staking cryptocurrencies into a blockchain protocol to generate tokenized rewards. The idea is to place bets or blockchain tokens in various DeFi applications to generate tokenized rewards that help maximize profits.
This allows the cryptocurrency liquidity provider to make high profits with a slightly higher risk, as their funds are allocated among the trading pairs and incentive pools with the highest trading fees and LP token payouts across multiple platforms. This type of liquidity investment can automatically place the user’s funds in the most profitable asset pairs.
The real value of crypto liquidity pools
Early on, DeFi DEX suffered from liquidity issues in the cryptocurrency market, trying to simulate traditional market makers. Liquidity pools helped solve this problem by motivating users to provide liquidity instead of having the seller and buyer match in the order book.
This provided a powerful decentralised solution to the DeFi liquidity problem and was instrumental in unlocking the growth of the DeFi sector. Liquidity pools may have appeared out of necessity, but their introduction offers a new way to algorithmically provide decentralised liquidity through incentivised, user-funded pools of asset pairs.
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