What Are Liquidity Pools?
A liquidity pool (LP) is a collection of tokens that are locked in a smart contract. While eliminating the need for centralized market makers, they enable users to easily trade cryptocurrencies on decentralized exchanges and other decentralized finance (DeFi) platforms.
Traditional financial markets such as stock, foreign exchange, and bond markets need to provide liquidity, thereby allowing trade of assets. There are some mechanisms that these markets employ for achieving liquidity. For instance, a stock market gets the required liquidity through order books. In this market, parties who want to buy or sell assets place orders, meaning that seller identify a quantity of the asset and buyer set a price. And a stock exchange does the process of matching the buy and sell orders to set a price for the asset.
Likewise, there has to be liquidity in a cryptocurrency market. Accordingly, cryptocurrencies can be swapped to other cryptocurrencies or even fiat currencies.
Digital assets can be traded automatically in a permissionless way on DeFi platforms by using automated market makers (AMMs) through liquidity pools.
on decentralized exchanges (trading platforms), pre-funded on-chain liquidity pools are used instead of the traditional order book for both the assets of the trading pair.
Liquidity pools’ main advantage is that a buyer and a seller do not need to make a decision about exchanging two assets on a specified price. When there is an enough liquidity, trades can be done with limited slippage even for the most illiquid trading pairs.
Users who want to generates passive income provide the needed fund for liquidity pools. Their deposit allows them to earn trading fees based on the amount of liquidity pool they offer. Therefore, everyone can act as a liquidity provider and market making can be made more accessible by AMMs.
How Do Crypto Liquidity Pools Work?
Users are usually incentivized to stake their digital assets in a pool. They are given rewards as they pool their cryptocurrencies. The rewards are often in the form of liquidity provider tokens (LP tokens). These tokens can be of high value, especially when they are used for different purposes throughout a DeFi ecosystem.
A perfect example of liquidity pools is Uniswap’s pool where supply of both ETH and USDC is kept. And it is managed by an AMM.
Users who buy USDC in exchange for ETH or vice versa pay a flat fee of 0.3%. This fee is taken even if the asset is of the least value. So, a fraction of these fees is paid to liquidity providers in proportion to their staking assets.
As long as liquidity providers participate in the pool, there is a steady supply of ETH and USDC. As a result, the pool is always operational.
What are the risks of liquidity pools?
When participants provide liquidity to an AMM, they may suffer loss, known as impermanent loss. At the time of taking part in these pools, they need to take an important fact into account that while the loss can be insignificant, it can also be huge.
When the price of the staking assets changes compared to the time they were deposited, impermanent loss happens, meaning that dollar value reduces at the time of withdrawal. As a result, as the change becomes bigger, the risk of impermanent loss increases.
Surprisingly, there is increasing number of liquidity providers regardless of impermanent loss. Thank to trading fees, this loss can be counteracted.
Another important fact that liquidity providers have to consider is the risk of bugs in the smart contract.
With the smart contract, middlemen holding the funds are removed. So, contract can be considered as the custodian of the funds. However, if there are some bugs or technical issues in the contract, the funds can be lost.
Sometimes, developers of specific projects have the access to change the contract code or the rules governing the liquidity pool. Therefore, before deciding to pool, doing a due diligence is necessary to make sure the developers do not have such a power.
Many technologists believe that liquidity pools are at the heart of DeFi technologies since they allow decentralized lending, trading, yield generation, and many others. If real world assets are connected with DeFi liquidity pools, a real financial revolution will definitely happen.