The DeFi ecosystem relies heavily on liquidity pools, which serve as the underlying technology for various functions such as automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, and blockchain gaming. Despite the simplicity of the concept, the potential of a pile of funds thrown together in a permissionless environment where anyone can add liquidity is huge.
The increasing adoption of DeFi has led to an explosion in on-chain activity, and as of December 2020, nearly $15 billion in value is locked in DeFi protocols. The rapid expansion of the ecosystem is due in large part to the essential role of the liquidity pool in various DeFi products.
In this article, we will go deeper into how DeFi has evolved the idea of liquidity pools.
What is a liquidity pool?
A liquidity pool is a digital mechanism for holding a collection of funds in a smart contract. This is a fundamental technology that enables decentralized trading and lending, among other things. The idea behind a liquidity pool is relatively simple; Users contribute equal values of two different tokens to a smart contract to create a market. Liquidity Providers (LP) are rewarded with trading fees proportional to their share of the total liquidity in the pool. As a result, liquidity pools have greatly improved the accessibility of market-making activities.
Liquidity pools have been instrumental in the rapid growth of the DeFi ecosystem. Decentralized finance is still a new field and liquidity pools have opened up several new opportunities for financial activity. They have enabled a wide range of innovative projects such as: B. Yield farming, synthetic assets, on-chain insurance and blockchain gaming. They have also made trading and lending more efficient, less expensive and less dependent on centralized intermediaries. As a result, they have attracted significant investment and attention from both retail and institutional investors.
To better understand how liquidity pools work, we first need to take a closer look at how Centralized Exchanges (CEX) work.
How do CEXes work?
The matching engine, along with the order book, is a fundamental part of any centralized exchange (CEX) as it enables efficient exchanges and supports complex financial markets. However, when it comes to on-chain execution of trades in DeFi trading, the order book poses a significant challenge due to the gas fees incurred with each interaction. This leads to high costs for market makers and limits the throughput capacity of the blockchain. On-chain order book exchanges are impractical on most blockchains like Ethereum as they cannot handle the high multi-billion dollar per day transaction volumes.
As such, assets on other networks generally cannot be traded without the help of cross-chain bridges and/or scalability solutions such as rollups. However, overall network throughput is often insufficient to support an on-chain order book exchange.
How do liquidity pools work?
Automated Market Makers (AMMs) have revolutionized on-chain trading by enabling decentralized trading without the need for an order book. Unlike order book exchanges where buyers and sellers are connected via the order book, trading occurs on an AMM peer-to-contract. This is made possible through the use of liquidity pools, which are collections of funds deposited into a smart contract by liquidity providers. Trades on an AMM are executed against the liquidity in the pool and not against a specific counterparty. In order for a buyer to buy, there does not need to be a seller at that point, only sufficient liquidity in the pool.
With AMMs, pricing is determined by algorithms based on the trades occurring in the pool. Liquidity providers earn trading fees from the trades taking place in their pool, proportional to their share of the total liquidity. Although anyone can become a liquidity provider, they are not considered a counterparty in the same sense as order book exchanges, as they do not interact directly with the buyer or seller. Instead, the smart contract that manages the pool manages the transaction.
It should be noted that the liquidity that allows AMMs to work has to come from somewhere. Unlike the order book model, however, liquidity providers are not directly linked to the buyers and sellers. Instead, they interact with the smart contract that governs the liquidity pool.
Because AMMs are based on blockchain technology, they are also inherently decentralized, allowing for greater transparency, security, and control over assets.
What are liquidity pools used for?
One of the main purposes of liquidity pools would be yield farming or liquidity mining, which are among the successful approaches for distributing new tokens to suitable parties in crypto projects.
The process involves users depositing funds into liquidity pools that serve as the basis for automated yield generation platforms like Yearn to generate returns. Tokens are algorithmically distributed to users who subsequently contribute their tokens to a liquidity pool, and newly minted tokens are then distributed in proportion to each user’s share of the pool.
In addition, tokens from other liquidity pools, namely pool tokens, can also be used. These pool tokens can be used to fund another pool and earn returns. Additionally, governance, insurance against smart contract risks, tranching, and minting synthetic assets on the blockchain are some new use cases supported by liquidity pools. The latter involves adding collateral to a liquidity pool, connecting to a trusted oracle, and creating a synthetic token that is linked to a desired asset. As this technology evolves, there are likely many more use cases for liquidity pools yet to be discovered and developed by DeFi developers.
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