You may have come across the theory of Liquidity pools in the Defi ecosystem.
But what are Liquidity Pools and how do they function? And why, in decentralized finance, do we really need them?
Liquidity pools provide a new standard to effectively trade shares while helping investors obtain a return on their investments. Here, we will discuss how they operate, their primary advantages, and their overall aspects.
Let us look into detail in this in-depth review now.
Table of contents
- What are Liquidity Pools?
- How do Liquidity Pools work?
- The Importance of Liquidity
- What are Liquidity Pools in Defi?
- How to Participate in a Liquidity pool?
- How do Liquidity Pool Exchanges work?
- Advantages of liquidity pools
- Liquidity Pool Risks
What are Liquidity Pools?
Liquidity pools apply to the pool of tokens locked in the smart contract. By offering liquidity, they guarantee trade and are used widely by some of the decentralised exchanges. Bancor made one of the first initiatives to incorporate liquidity pools, and Uniswap made it widely popular.
Liquidity Pools are the trading aspect of a decentralised exchange. Their role is to increase the market’s liquidity among market participants.
How do Liquidity Pools work?
In its simplest form, a single liquidity pool contains 2 tokens and each pool establishes a new market for the same pair of tokens. DAI / ETH may be a clear example of a popular liquidity pool at Uniswap.
The first liquidity provider when a new pool is created, is the one who decides the initial price of the assets in the pool. The liquidity provider is encouraged to provide to the pool an equivalent value of all tokens.
Based on the liquidity supplied to a pool, the liquidity provider (LP) receives special tokens called LP tokens in proportion to how much liquidity they supply to the pool. A 0.3 % cost is proportionally allocated to all LP token holders when a sale is enabled by the pool.
They would burn their LP tokens if the liquidity provider wishes to get their underlying liquidity back, plus any unpaid fees. According to a deterministic pricing algorithm, each token swap encouraged by a liquidity pool results in a price shift. This process is also called an automatic market maker (AMM).
A constant commodity market maker algorithm is used by basic liquidity pools such as those used by Uniswap, which means that the quantities of the 2 tokens given still stays the same. On top of that, a pool will still have liquidity, no matter how massive a trade is, because of the algorithm. The primary reason for this is that, as the target quantity increases, the algorithm asymptotically increases the token’s price.
The Importance of Liquidity
The fact that liquidity is so important is that it largely determines how an asset’s price can shift. A relatively limited number of open orders are open on all sides of the order book in a low liquidity market. This suggests that one transaction could shift the price in any direction significantly, making the stocks unpredictable and unattractive.
Liquidity pools are an important part of the revolution of Decentralized Finance (DeFi) which appears to have great potential. Usually, these pools facilitate the swap of a large number of assets with any other supported asset.
What are Liquidity Pools in Defi?
Liquidity pools aim to address the low liquidity problem successfully and thus guarantee that the price of a token does not swing significantly after performing the order of a single large trade.
Decentralized exchanges offer bonuses to those who invest in the liquidity pools in order to maximize customer engagement. The user has to deposit money into the liquidity pool to engage and reap the benefits. liquidity pools are being regulated by one or more smart contract protocols. The number of funds that need to be invested and the proportionate ratio of each token will vary between different DeFi platforms.
How to Participate in a Liquidity pool?
To deliver $50 of liquidity into an ETH / USDC pool, it needs a deposit of $50 worth of ETH and $50 USDC. A total deposit of $100 is required in this situation. In return for it, the liquid provider will collect liquidity pool tokens. Such tokens reflect their proportional pool share and allow them to withdraw their pool share at any time.
Anytime a seller places a trade, a trading fee is deducted from the transaction and the order is sent to the smart contract containing the liquidity pool. The trading fee is set at 0.3% for most decentralized exchanges. In our case, if you deposit $50 ETH and $50 USDC and you make up 1 % of the pool with your donation. You will then get 1 % of the 0.3 % trading fee for any of the particular trades.
How do Liquidity Pool Exchanges work?
There are two types of decentralised exchanges in the DeFi space at present which are:
1) Order Book Exchanges:
The order book exchanges depend on a bid /ask scheme to satisfy transactions. Orders get redirected to an order book when a new buy or sale order is made. Then the matching engine of the exchange executes matching orders for the same price. Examples: 0x and Radar Relay
2) Liquidity pools Exchanges:
They exclude emphasis on order book dealing from the exchange. Thus they enable the exchange to ensure the liquidity level is steady. Example: Kyber, Uniswap, and Curve Finance.
Advantages of liquidity pools
1) Guaranteed liquidity at every price level:
Traders do not have to be directly connected to other traders, because liquidity is constant as long as customers have their assets invested in the pool.
2) Automated pricing enables passive market making:
Liquidity providers actually deposit their funds into the pool and pricing is taken care of by the smart contract.
3) Anyone can become a liquidity provider and earn:
liquidity pools do not need any listing fees, KYCs, or other obstacles linked with centralized exchanges. If an investor wants to provide liquidity to the pool, they will deposit the equivalent value of the assets.
4) Lower gas fees:
The gas costs are reduced due to the minimal smart contract design offered by decentralized exchanges like Uniswap. Effective price calculations and fee allocations within the pool imply less volatility between transactions.
The returns from the liquidity pool depend on three factors:
1) The asset prices when delivered and withdrawn,
2) The size of the liquidity pool, and
3) The trading volumes.
It is very important to remember that, relative to what they originally invested, investors would actually end up removing a particular ratio of assets. This is where the market movement can either work for or against.
Liquidity Pool Risks
And of course, like with everything in DeFi we have to remember about potential risks. some of the liquidity risks associated are listed below:
- Impairment loss
- Possible smart contract bugs.
- Liquidity pool hacks
- Systemic risks
If you give liquidity to an AMM, you must understand the concept of impermanent loss. When you provide liquidity to an AMM, it’s a loss in dollar amount compared to HODLing.
You’re probably exposed to impermanent loss if you provide liquidity to an AMM. It might be small at times and significant at others. If you’re thinking about investing in a two-sided liquidity provider, remember to read our article first.
Another thing to think about is the risks of smart contracts. When monies are deposited into a liquidity pool, they become part of the pool. While no intermediaries are holding your assets, the agreement itself might be considered the custodian of your funds. Your funds might be lost for good if there is a flaw or some form of exploit, including through a flash loan.
Also, be aware of projects where the creators have the authority to change the pool’s regulations. Within the smart contract code, programmers may have an admin key or other privileged access. This could allow someone to do anything evil, such as seize control of the pool’s cash.
Like all other tokens, a user can use the liquidity pool tokens during the period of the smart contract. A user can therefore deposit this token on a different platform that accepts the liquidity pool token in order to get additional yield to maximise the return.
Therefore, the user can compound two or three interest rates by using yield farming, and eventually increase the returns.
Liquidity pools offer easy to use platform for both users and exchanges. The user does not have to meet any special eligibility criteria to participate in liquidity pools, which means that anyone can participate in the provision of liquidity for a token pair.
Thus in the DeFi ecosystem, liquidity pools play an essential role, and the concept has been able to enhance the level of decentralization.