The financial world lives from liquidity. With no funds available, financial systems grind to a halt. DeFi or decentralized finance— a collective term for financial services and products on the blockchain — is no different.
DeFi activity B. lending, borrowing or token exchange, are based on smart contracts – pieces of self-executing code. DeFi protocol users “lock” crypto assets into these contracts, called liquidity pools, for others to use.
Liquidity pools are a crypto industry innovation and have no immediate equivalent in traditional finance. Liquidity pools not only provide a lifeline for the core activities of a DeFi protocol, but also serve as a breeding ground for investors with an appetite for high risk and high returns.
How do liquidity pools work?
Look beyond the jargon and you will find that the basic principles of liquidity pools are intuitive. For economic activity to take place in DeFi, there must be crypto. And that cryptocurrency has to be provided somehow, and that’s what liquidity pools are supposed to do. (That role is played by order books and market markers on centralized exchanges, but that’s another story.)
When someone sells token A to buy token B on a decentralized exchange, they rely on tokens in the A/B liquidity pool provided by other users. If they buy B tokens, there will now be fewer B tokens in the pool and the price of B will increase. This is a simple supply/demand economy.
Liquidity pools are smart contracts containing locked crypto tokens provided by the platform’s users. They are self-governing and do not require intermediaries to function. They are supported by other pieces of code, such as automated market makers (AMMs) that use mathematical formulas to help maintain balance in liquidity pools.
Did you know?
Bancor pioneered the underlying concept of AMMs in 2017. And in 2018, Uniswap, now one of the largest decentralized exchanges, popularized the overall concept of liquidity pools.
Why is low liquidity a problem?
Low liquidity leads to high slippage – a large difference between the expected price of a token trade and the price at which it actually executes. Low liquidity leads to high slippage as token changes in a pool due to a swap or other activity lead to larger imbalances when so few tokens are locked in the pools. If the pool is very liquid, traders will not experience much slippage.
However, high slip is not the worst case scenario. When there is insufficient liquidity for a given trading pair (e.g. ETH to COMP) across all protocols, users are stuck with tokens they cannot sell. That’s pretty much what happens carpet pullsbut of course it can also happen if the market does not provide enough liquidity.
How much liquidity is there in DeFi?
Liquidity in DeFi is typically expressed as “total value locked” which measures how much crypto is entrusted to the protocols. According to the metrics website, the TVL in all DeFi was $50 billion in March 2023 DeFi Flame.
TVL is also helping to capitalize on DeFi’s rapid growth: in early 2020, Ethereum-based protocols recorded a TVL of just $1 billion.
Why provide liquidity to a pool?
Providing liquidity can be lucrative for investors. Protocols incentivize liquidity providers through token rewards.
This incentive structure has led to a crypto investment strategy known as yield farmingwhere users move assets across different protocols to take advantage of returns before they dry up.
Most liquidity pools also provide LP tokens, a type of receipt that can later be exchanged for rewards from the pool – proportional to the liquidity provided. Investors can sometimes bet LP tokens on other protocols for even more returns.
However, beware of the risks. Liquidity pools are prone to this ephemeral loss, a term used when the ratio of tokens in a liquidity pool (e.g. 50:50 ETH/USDT split) becomes uneven due to significant price changes. This could result in the loss of your invested funds.
Who Uses Liquidity Pools?
- 📏 1inch – a decentralized exchange aggregator that works across multiple chains
- 💰 Aave – a decentralized lending platform
- 🔄 Uniswap – a decentralized exchange for exchanging Ethereum-based tokens
How can you add liquidity?
There are basically two ways to add liquidity.
If you want to add funds directly to a liquidity pool like ETH/USDC Liquidity pool on SushiSwapyou need equal amounts of ETH and USDC, which you can trade through any decentralized exchange.
In general, you need an equal pair of tokens because trading, borrowing, and most other DeFi activities are almost always two-way: you trade ETH for USDC, you borrow DAI for ETH, and so on. Therefore, most protocols require liquidity providers to pledge the equivalent (50/50) of two crypto assets to available pools in order to maintain a balanced pair. (Balancer took an innovative approach and allowed up to eight tokens in a liquidity pool.)
But there is also a less complicated way.
Via platforms like Zapper, which invented the concept in 2020, you can “zap” into a liquidity pool and add liquidity in just one transaction. Just go to zapper.fi and connect your wallet. Click on “Pools” to list the liquidity pools available for entry and exit. Add liquidity to the pool by using all of your assets. Zapper exchanges them for equal divisions of the corresponding pair. This saves a few separate transactions!
However, Zapper does not list all liquidity pools on DeFi and limits your options to the largest ones.
The future of liquidity pools
Liquidity pools operate in a competitive environment and generating liquidity is a difficult game when investors elsewhere are constantly seeking high yields and are taking liquidity with them.
Nansen, a blockchain analytics platform, found that 42% of yield farmers who provide liquidity to a pool on the start day exit the pool within 24 hours. By the third day, 70% will be gone.
To address this problem known as “mercenary capital,” OlympusDAO has been experimenting “Protocol native liquidity.” Rather than establishing a liquidity pool, the protocol allows users to sell their cryptocurrencies to the Treasury in exchange for the discounted protocol token OHM. Users could employ OHM to get high yields.
But the model has encountered a similar problem: investors who just want to cash out the token and turn to other opportunities, undermining confidence in the sustainability of the protocol.
Until DeFi solves the transactional nature of liquidity, no major changes are on the horizon for liquidity pools.
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