Until recently, accessing liquidity was like having an exclusive pool party in the Hamptons.
It wasn’t for everyone: you had to know a banker or someone on Wall Street to get in. Admission requirements were strict: you were only allowed to wear white or linen. The waiting time was also very long: you had to find the right time to be greeted by the party host. Finally, the benefits you got were minimal: you lost interest after a few minutes of boring conversation and left the party hungry (that’s what fancy canapés do to you).
But today you are invited to another party. A party organized by a group of like-minded people a little over a thousand miles south in Miami.
It’s a more inclusive party: you don’t have to know the host, just a friend of a friend will let you in. Participation requirements are much more flexible: just come as you are and bring what you can. There’s no waiting: this is everyone’s party. More importantly, you can really have a good time here: the people have their own personality, they share interesting ideas and the food is out of this world.
This is how it is to get into a liquidity pool in DeFi.
Offering high yields and greater borrowing opportunities, it’s no surprise that decentralized global liquidity pools have exploded in popularity in recent years.
To put things in perspective, at the time of this writing, the total value locked in DeFi liquidity pools is $108.48 billion.
So, if you are a new crypto retail investor or a small business looking for new and innovative ways to raise funds, read on.
Liquidity pool in plain language
A liquidity pool can be thought of as a pot of cryptocurrency assets locked in a smart contract that can be used for exchanges, lending, and other applications.
With traditional finance (Centralized Finance or CeFi), liquidity is provided by a central organization such as a bank or stock exchange.
Banks have lengthy and paper-intensive processes, cumbersome and costly infrastructures, and minimize their risk by only supporting organizations that meet strict criteria. This leaves companies with less formalized governance processes, no publicly available information, and insufficient assets to use as collateral outside the party.
A traditional exchange is another place where liquidity can be accessed. But they come with their own limitations. Because buyers are looking for the lowest prices and sellers are trying to get as much as possible, the two parties may not agree on a price.
Sometimes there is not enough liquidity on the exchange to fill a buyer order. Delays then occur as traders have to wait for another buyer or seller to place an order.
This is the traditional order book model, the limitations of which market makers (MM) like Coinbase or Gemini have tried to overcome.
MMs are centralized exchanges that are always ready to buy or sell assets at a specific price, thereby providing a place for buyers and sellers to meet and trade.
MMs often use their own assets and ensure there is always liquidity in their exchange. Because of this, users can trade 24/7 without delay (unlike traditional stock markets like Wall Street, which opens at 9:30am and closes at 4:00pm EST).
While MMs are an improvement over traditional exchanges, their transactions are relatively slow (they operate as a centralized exchange based on the order book model) and costly (due to the significant fees they charge traders for facilitating transactions).
With DeFi and the introduction of Automatic Market Makers (AMM), a new and better access to liquidity has emerged. AMMs are smart contracts that regulate trade. Because they are decentralized, they allow buyers and sellers to trade directly with each other without the need to be matched by a central market maker via the order book model.
Call it peer-to-peer trading — or peer-to-contract trading, since users trade directly against a smart contract.
How Liquidity Pools Work
In DeFi, traders provide liquidity to decentralized exchanges (DEXs). They work like traditional exchanges but are not affected by their weaknesses such as lengthy transactions, high gas fees and slippage.
When traders lock their assets in a smart contract, a liquidity pool is created. We can define a “pool” as the sum of at least two tokens locked in a smart contract.
And why should traders do that? Because they are rewarded for it.
Liquidity protocols that act as AMMs are Uniswap, Bancor or Balancer. They offer rewards to liquidity providers in the form of shares in transaction fees or additional cryptocurrency tokens.
Often it is only possible to get a token when it is started. And there are also users who participate in liquidity pools because they believe in a decentralized project and want to benefit from the governance rights that some tokens offer.
Would you like to see practical examples? Here are some for you.
For the purposes of this article, it is important to note that liquidity providers can generate high returns not only through native tokens and transaction fees, but also through lending cryptocurrencies – especially stablecoins.
These rates far exceed those paid by traditional banking services. It’s common to find pools offering 110% – or even up to 90,000% APR.
The rewards are of course proportional to the risks. Temporary losses and a total loss of funds from smart contract defaults or malicious carpet pulls can and do happen.
As DeFi achieves mass adoption, these risks will diminish (and with them lucrative rewards), but not the benefits that liquidity pools offer.
The most comprehensive liquidity pool party begins
As of today, cryptocurrencies are the primary source of liquidity in DeFi.
But what about SMEs and individuals who cannot access finance through existing channels today?
The International Finance Corporation (IFC) estimates that 65 million businesses, or 40% of formal micro, small and medium-sized enterprises (MSMEs) in developing countries have unmet financing needs of US$5.2 trillion per year.
Cash-strapped, these companies are looking for ways to get funding faster and on their own terms, without relying on central institutions. They don’t have crypto wallets and are unfamiliar with the complexities of the new ecosystem.
The only way for them to access new funding is to be included in DeFi as genuine asset originators so that they can use their invoices, inventory, letters of credit, royalties, etc. as collateral.
Connecting real world assets to DeFi liquidity pools will bring about a real financial revolution.
Millions of companies around the world are clamoring for new financing opportunities. Let’s get her through the door.
Then the best pool party begins.
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