DeFi needs no introduction due to its relevance in the blockchain space. This alternative financial system allows users to leverage their cryptocurrency holdings to huge profits. It continues to outperform traditional financial systems in creating value for investors. No wonder this aspect of blockchain is growing and gaining traction among investors, introducing them to many financial use cases – those that already exist and those that are new.
An important factor behind the thriving DeFi ecosystem and its popular applications is the presence of liquidity, which allows users to easily take advantage of all types of use cases. While centralized systems incentivize institutions or individuals with large amounts of money to enter markets, DeFi allows any user to provide liquidity. In the process of providing liquidity, individual users can expect to make enormous profits that have not been possible with conventional instruments so far. This is made possible by applications, so-called liquidity pools, which, in addition to user incentives, are also responsible for the functioning of the entire DeFi ecosystem.
What are liquidity pools?
Liquidity pools are DeFi’s on-chain answer to liquidity delivery, keeping the whole process decentralized, autonomous and affordable. Known as Liquidity Providers (LPs), users deploy their cryptocoins and tokens in smart contracts to keep assets liquid and receive significant compensation in return.
Liquidity pools are found on AMM DEXs, lending-borrowing protocols, and yield farms that allow users to exchange, borrow, or wager cryptocurrencies. The most popular implementation is often within AMM-DEXs, which allow users to trade the tokens they own for the tokens they want from the pool. Liquidity pools therefore make central market makers and order books on DeFi exchange platforms obsolete.
How liquidity pools work
The removal of important components from CEXs makes the workings of DEXs and the liquidity pools behind them extremely interesting. Liquidity pools rely on smart contracts to hold the cryptocurrencies wagered by the user, control the prices of the tokens in the pool, and execute trades for the user.
Liquidity pools work as follows: LPs put cryptocurrency pairs into these pools at a 50/50 ratio. Although liquidity pools contain more than two cryptocurrencies in different ratios on certain protocols, the most common pools have the aforementioned configuration. For example, ETH/USDT pools are common on the AMM-DEXs running on the Ethereum blockchain.
While in the pools, the value of the liquidity is maintained by algorithms based on supply and demand created by trading activity. These algorithms, called Automated Market Makers (AMMs), automate processes such as providing liquidity and determining token prices. Thus, liquidity pools can replace centralized order books and the order books implemented on-chain – which are expensive and cumbersome to operate in crowded networks.
Due to smart contract automation, liquidity pools do not require counterparties to match their trades. Order book exchanges work by bringing together different parties who want to sell and buy assets. However, liquidity pool deals are peer-to-contract deals. In peer-to-contract exchanges, users acquire assets from liquidity pools by escrowing the other asset in the pair in a process called “swapping.” Considering the ETH/USDT pools that exist in the Ethereum DEXs, a user who wants to acquire ETH has to deposit an equivalent USDT value into the pool.
LPs provide liquidity in such liquidity pools by using equivalent values of both assets in the pair – a $1,000 ETH stake would justify a $1,000 USDT stablecoin. The AMM algorithm keeps the price of the assets relative to each other. As the value of USDT remains stable, the value of ETH in the pool will vary based on frequency or scarcity due to the swaps experienced.
With any cryptocurrency exchange, LPs are incentivized by transaction fees charged from users and other rewards depending on the liquidity pool. Transaction fees are paid to LPs in proportion to their share of the pool. Upon depositing their funds into the liquidity pool, LPs receive LP tokens representing their share of the contribution to the pool. Aside from allowing LPs to withdraw their contribution from the pool, these LP tokens can also, in some cases, be used to earn additional rewards through yield farming. Yield farming contracts allow DeFi participants to stake their LP tokens on a farming contract for rewards on top of stake rewards from liquidity pools. Yield farming, also known as liquidity mining, provides LP token holders with an incentive to maintain their share of the liquidity pool over a longer period of time.
Despite the potential for huge returns, users need to be wary of the risks associated with liquidity pools. From carpet robbery and exit fraud to market movements and volatility, cryptocurrencies are high-risk investments, especially when betting on profits in DeFi protocols. One of the most common risks associated with liquidity pools is temporary loss.
Volatile loss – a liquidity pool risk
Impermanent loss is a phenomenon associated with liquidity pools where users experience a relative depreciation in the value of their deployed assets that would be worth more if they chose not to use them at all. Such a loss arises as a result of market movements when the value of the assets employed rises or falls. Because the value of the assets in liquidity pool pairs is relative to one another, larger market moves in the same assets present arbitrage opportunities.
Therefore, arbitrage traders take advantage of price differences between the same assets in liquidity pools and other markets such as centralized crypto exchanges. The swaps performed by the arbitrage traders leave a disproportionate ratio of tokens in the pool, often resulting in a dilution of the number of tokens that have increased in value or an increase in the number of tokens that have decreased in value. This often leads to a scenario where the total value of the pool at that point is comparatively less than it would have been if the pool’s users had stuck with their original investments. Although the value of the user’s share of the pool may be greater than their original stake, on paper they are still suffering a comparable loss due to the changing ratios of assets.
This type of loss is known to be temporary as it can be recovered when the value of the tokens returns to their original price. It only becomes permanent if the user withdraws their share at the moment when their investments are negatively affected by market fluctuations. In addition, the trading commissions and rewards earned from the pool can make up for their loss at times. However, it is still important to be aware of the existence of this phenomenon before users engage in staking liquidity pools.
Liquidity pools make DeFi applications work
Despite the risks associated with providing liquidity in DeFi, liquidity pools can make huge amounts of money for users. A thorough understanding of how they work will help users invest their funds more safely while also benefiting from and benefiting the DeFi ecosystem. Currently, liquidity pools make up, and will continue to make up, a large portion of the liquidity flowing through DeFi protocols. Therefore, liquidity pools play a very important role in the decentralized world as they enable the functioning of all dApps that need liquidity.
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