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 such as lending, borrowing or swapping tokens 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 direct equivalent in traditional finance. Liquidity pools not only provide a lifeline for the core activities of a DeFi protocol, but also serve as breeding grounds for investors with an appetite for high risk and high returns.
How do liquidity pools work?
If you look beyond the jargon, you’ll find that the rationale behind liquidity pools is intuitive. For economic activity to take place in DeFi, there must be crypto. And that crypto needs to be provisioned somehow, and that’s exactly what liquidity pools are supposed to do. (This role is fulfilled 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 are now fewer B tokens in the pool and the price of B will increase. This is simple supply/demand economics.
Liquidity pools are smart contracts containing locked crypto tokens provided by the platform’s users. They are self-executing 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.
Bancor was a pioneer 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.
The story goes on
Why is low liquidity a problem?
Low liquidity leads to high slippage – a big difference between the expected price of a token trade and the price it actually executes at. Low liquidity leads to high slippage as token changes in a pool as a result of a swap or other activity cause larger imbalances when so few tokens are included in pools. If the pool is very liquid, traders will not experience much slippage.
But high slip is not the worst possible scenario. If there is insufficient liquidity for a given trading pair (e.g. ETH to COMP) across all protocols, users will be stuck with tokens they cannot sell. That’s pretty much what happens with 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 protocols. In March 2023, the TVL across DeFi was $50 billion according to the Metrics site DeFi Flame.
TVL is also helping to capture DeFi’s rapid growth: in early 2020, Ethereum-based protocols recorded a TVL of just $1 billion.
Why add 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 offer LP tokens, a kind of receipt that can later be exchanged for rewards from the pool – proportional to the liquidity provided. Investors can sometimes stake LP tokens on other protocols for even more returns.
Here comes Andre and Dani’s new DeFi game
However, beware of risks. Liquidity pools are vulnerable to impermanent loss, a term for when the ratio of tokens in a liquidity pool (e.g. ETH/USDT 50:50 split) becomes uneven due to significant price changes. This could result in you losing 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 swapping Ethereum-based tokens
How can you add liquidity?
Broadly speaking, there are two ways to add liquidity.
If you want to add funds directly to a liquidity pool like ETH/USDC Liquidity pool on SushiSwapyou need to have equal amounts of ETH and USDC to trade through any decentralized exchange.
You generally need an equal pair of tokens as 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. As a result, most protocols require liquidity providers to pledge the equivalent (50/50) of two crypto assets to available pools so that a balanced pair can be maintained. (Balancer has taken an innovative approach and allows up to eight tokens in a liquidity pool.)
But it’s also less complicated.
You can “zap” into a liquidity pool – add liquidity in just one transaction via platforms like Zapper, which invented the concept in 2020. Just go to zapper.fi and connect your wallet. Click on “Pools” to list the liquidity pools available for zapping in and out. Add liquidity to the pool using whatever assets you have. Zapper exchanges them for equal splits of the appropriate 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 highly competitive environment, and generating liquidity is a tough game when investors elsewhere are constantly chasing high yields and taking liquidity.
Nansen, a blockchain analytics platform, found that 42% of yield farmers who provide liquidity to a pool on launch date exit the pool within 24 hours. By the third day, 70% is gone.
To address this problem known as “mercenary capital,” OlympusDAO has been experimenting “Protocol Liquidity”. Rather than establishing a liquidity pool, the protocol allows users to sell their crypto into its treasury in exchange for discounted protocol token OHM. Users can use OHM for high yields.
But the model ran into a similar problem – investors who just want to pay out the token and other opportunities, reducing confidence in the sustainability of the protocol.
Until DeFi solves the transactional nature of liquidity, there are no big changes on the horizon for liquidity pools.
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
Comments are closed.