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What are liquidity pools? | How does bitcoin and crypto work?

The importance of liquidity pools

The fundamental building block of any financial market is an exchange – a place where buyers and sellers meet to make a market. In traditional finance, this has always required a trusted third party to broker the trade. The crypto industry revolutionized this dynamic by removing the need for the trusted middleman with the advent of decentralized exchanges (DEXs). Unfortunately, DEXs (and crypto in general) have had a fatal liquidity problem.

High liquidity is one of the most important attributes for any financial market as it allows for quick and efficient financial transactions. Early DEXs were so illiquid that they were practically unusable. Liquidity pools helped change that. Shortly after the emergence of liquidity pools, DEXs started to flourish and with them the entire DeFi ecosystem exploded.

Liquidity pools are not only useful in DEXs. They add liquidity to almost every DApp in DeFi. Lending protocols, yield farming, prediction markets, insurance, and more use liquidity pools to make financial transactions smoother.

How do liquidity pools work?

There are two key considerations for how liquidity pools work: 1) the technicalities of depositing crypto assets into a pool, and 2) the psychological aspect of getting people to deposit their assets.

The technical details may vary from project to project, but generally follow the same pattern. A smart contract accepts specific cryptoasset deposits. The limitations of what is accepted and in what proportion may differ. For example, most DEX liquidity pools represent trading pairs, meaning that depositing into the pool requires an equal amount of the two crypto assets that make up the pair. The VERSE WETH pool requires VERSE and WETH of equal value based on the current market price of the DEX.

Funds may or may not be locked for a period of time after depositing in the pool. The smart contract mints and sends you a token, which is a kind of receipt. This token is used to realize pending rewards from your position and withdraw your deposited crypto assets. The ratio of returned cryptoassets may be different than when you started.

Getting people to participate in liquidity pools was an age-old challenge. Traditional financial institutions like banks attract liquidity by paying interest on deposits, although interest rates on bank deposits have long been quite low. Liquidity pools provide returns in the form of fee sharing.

What are liquidity pools used for?

DEX: Most DEXs use an automated market maker (AMM) model as opposed to centralized exchanges which use an order book model. An order book matches buyers and sellers directly. AMMs match buyers and sellers to a liquidity pool. Liquidity providers receive a proportionate share of the fees incurred when trading assets in a given liquidity pool.

loan: In traditional finance, banks or other large financial institutions take people’s deposits, lend them, and collect interest on the loans. In DeFi, you put your assets into a liquidity pool and people can borrow money from the pool. Depositors receive a portion of the interest paid by borrowers. The difference is that since banks are in a very privileged position, they get most of the interest from loans, while the much more competitive DeFi protocols take a much smaller percentage.

prediction market: Individuals who contribute to a liquidity pool earn a percentage of each trade proportional to their ownership of the liquidity pool. Liquidity pool positions in the prediction market must be entered into and closed out with care as they can be very volatile.

Insurance: People can deposit funds into a liquidity pool that is used to pay out insurance claims in the unfortunate event of adverse events such as money lost due to smart contract failures or insolvent exchanges. Liquidity providers earn a portion of insurance fees.

The benefits and risks of liquidity pools

Using liquidity pools has two main benefits, one financial and one social. Of course, the main financial benefit is that you earn rewards by holding your cryptoassets in a liquidity pool. The societal good is that liquidity providers help create more economic freedom in the world. How? DeFi needs liquidity. Making DeFi DApps more liquid makes DeFi a viable alternative to the centralized financial system. A decentralized alternative to centralized financing brings more economic freedom to all, but especially to developing markets or repressive regimes.

Depositing your crypto assets in a liquidity pool involves risk. The most common risks come from DApp developers, smart contracts, and market volatility. DApp developers could steal or waste deposited assets. Smart contracts can have bugs or exploits that lock or allow for theft of funds. Market volatility can cause what is known as impermanent loss, which largely affects DEX liquidity pools.

The best way to mitigate the risks of yield farming is to research projects before you deposit anything and stick to projects with a long track record.

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