Liquidity pools are collections of cryptocurrencies used to facilitate trading between different assets on decentralized exchanges.
Centralized Exchange like Bitstamp, bring together buyers and sellers (traders) who transfer assets based on an agreed price. This model is called a order bookbecause all orders and their prices are recorded individually in a list.
Blockchain technology’s use of smart contracts introduced another model for exchanges between assets called automated market makers (AMMs). Liquidity Pools are a crucial part of this process. Breakdown of the term: liquidity refers to assets that can be traded in the market and pools are collections of crypto coins/tokens that are grouped together.
Many decentralized exchange Use liquidity pools as collective sources of assets for traders to interact with. This functionality is one of the main drivers of the expansive decentralized finance (DeFi) ecosystem.
How do liquidity pools work?
Although liquidity pools have many complexities, their basic function is relatively simple. Let’s take an example of a pool containing ETH and USDC.
Liquidity Provider (LPs) lock an amount of ETH and USDC in a dedicated smart contract containing the assets (the Swimming pool). Other users looking to switch between ETH and USDC are turning to the liquidity pool as a source of wealth. For example, one could deposit some ETH into the pool and receive a corresponding value from USDC (or vice versa).
The swappers pay a small fee to use the pool, and this fee is distributed among the LPs to motivate them for the services they provide. Generally, LPs are issued in another cryptocurrency called LP token giving them the right to charge a percentage of all fees proportional to the amount of liquidity they provide to the pool. In other words, the more assets LPs lock, the more LP tokens they receive and the higher the percentage of fees they charge.
Although this basic mechanism underlies all liquidity pool based swaps, there are many variations. For example, some platforms offer liquidity providers the opportunity to stake their LP tokens and generate additional rewards. This is a form of popular practice in DeFi called yield farming.
Automated Market Maker
The platforms that use liquidity pools to operate digital asset swaps are called Automated Market Makers (AMMs). AMMs are smart contract-based protocols that dictate how LPs, liquidity pools, LP tokens, and other related functions work together.
A key function of an AMM is to ensure that asset valuations remain accurate so that users trading swaps do not lose (or gain) value compared to their crypto’s market prices. One way to do this is to stabilize asset prices according to their fluctuations within a liquidity pool. In the ETH/USDC pool example above, this means that if ETH is deposited and USDC withdrawn, the total quoted price of ETH will decrease and USDC will increase, leaving a constant total value in the pool. The math behind this rule is called Constant product formula.
To ensure price stability, AMMs also rely on 1) arbitrage trader trading across markets to exploit price differentials, and 2) oraclewhich are tools that transmit real-world information to blockchain-based systems.
Decentralized exchanges using liquidity pools
Some of the most popular AMM-based DEXs that use liquidity pools are:
- banking – DEX protocol that invented the AMM model in 2017. It uniquely matches user deposits by injecting its native BNT token into each liquidity pool, allowing users to make unilateral deposits (i.e. providing liquidity with one token instead of two).
- Uniswap – popularized the AMM model and is deployed on Ethereum, the Polygon sidechain, and Layer 2 solutions like Optimism and Arbitrum.
- Curve – focuses on hosting stablecoin pools with the aim of helping investors participate in providing liquidity without having to contribute more volatile assets.
What are the benefits and risks of using liquidity pools?
AMM-based liquidity pools use automated blockchain technology that allows users to exchange digital assets without having to rely on centralized entities. Rather, the use of liquidity pools relies on trusting publicly available code.
However, since liquidity pools are subject to strict rules coded into smart contracts, they can also be vulnerable to attacks by hackers if this code has vulnerabilities.
Another risk of using liquidity pools is impermanent loss, which can happen if the two pooled assets fall in value due to market conditions or the swaps themselves. The loss is said to be “impermanent” if the assets remain in the pool, but these become permanent, realized losses if/when the user removes their funds from the pool.
The most important thing for liquidity pools
- Liquidity pools are collections of different cryptocurrencies used by traders looking to switch between assets.
- Liquidity pools rely on the interaction between liquidity providers (LPs), who lock their crypto in smart contracts, and users (including arbitrage traders), who exchange their crypto with the locked funds for a fee paid back to LPs.
- The automated market maker (AMM) model, which uses liquidity pools, was pioneered by decentralized exchange Bancor and popularized by Uniswap.
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