The financial freedom and control that decentralized finance offers users has fueled the rapid growth of the DeFi sector. Liquidity pools and automated market makers (AMMs) are a key reason for DeFi’s huge utility.
Introduction to DeFi
It’s easy to see why Decentralized Finance (DeFi) is booming. The benefits that DeFi brings are what many people want. Many people want the freedom to do what they want with their finances. Easy access to financial services without the bottlenecks of central banks or government is a need that resonates with most people. These and many other problems have been solved by DeFi. DeFi has become such a fast-growing trend because of the sense of financial freedom and control it offers.
DeFi cannot run on the structure of centralized systems. In order for it to break away from centralization, a new framework is needed to propel it forward. There are a number of structures that power DeFi behind the scenes to provide the services we all enjoy. One of these structures are so-called liquidity pools. Let’s explain in simple terms what Liquidity Pools are all about.
What is liquidity?
Before talking about pools, it is important to understand what liquidity is. In very simple terms, liquidity refers to the amount of money that is available for settlement. It describes how easy it is to convert an asset from one form to another. Before the advent of cryptocurrencies, it meant how easy it is to sell an asset for cash. Now, in terms of crypto, it refers to how easy it is to exchange one particular crypto asset for another.
In order for the conversion from one crypto token to another to be possible without any problems, a sufficient number of the tokens concerned must be available. This ensures that requests from users are met regardless of the volume requested. It also ensures that there are minimal price differences as demand is always balanced by supply.
Another important requirement is time. Low-liquidity systems do not have sufficient volume to meet user needs. This means that if the volume demanded exceeds the available liquidity, there may be delays in settlement.
From the above we can see that an exchange needs to have good/high liquidity. If not, users will have a very bad trading experience.
Decentralized exchanges (DEXs) must have high liquidity. One of the goals of decentralized finance is to provide users with a better experience than centralized exchanges that have tons of liquidity.
Then what is a liquidity pool?
It is simply a pair of crypto assets. This pair is locked by a smart contract. It forms an aggregate stock of assets pooled by investors. Liquidity pools are the backbone of DeFi. Without them, DeFi would not be able to offer financial services to people.
Why are liquidity pools important in decentralized finance?
LPs are a very important support structure for DeFi. Here are several reasons why they are so important.
- They help ensure that there is always sufficient liquidity in the system to be able to fulfill orders at any time. Merchants don’t need to search who to buy from or sell to.
- It guarantees a fast transaction time.
- decentralization
Liquidity pools provide a way through which a DeFi platform can be governed. The high liquidity of a DeFi platform gives people confidence in the platform. Liquidity providers on the platform are often granted governance rights through utility tokens. These tokens are provided as liquidity incentives and allow users to propose changes and improvements to the platform.
Characteristics of liquidity pools
- Virtually hassle free.
With LP, a trader doesn’t have to look at order books, at charts, or at tracking prices. He just goes to the LP platform and settles transactions without undue stress.
- They’re really decentralized.
Centralized exchanges with their order books were a helpful start in the early days of crypto. The problem with them is their centralized operation. Normally you have to disclose personal data via KYC. Sometimes you are unable to transact due to the country you are from or because your balance does not meet the minimum amount set by the CEX for a trade. With platforms running on liquidity pools, these obstacles to financial freedom do not exist.
- Lower transaction fees
In general, LP platforms have lower gas costs compared to their centralized counterparts. This is mainly due to the efficiency in designing smart contracts used in LP platforms.
How does a liquidity pool work?
Liquidity in a pool is provided by anyone who wishes to contribute to the pool. In its simplest form, an LP is denominated in a pair of cryptocurrencies, such as BNB-USDT.
To provide liquidity, an investor must deposit the two crypto assets into the pool. The amount of the two assets must be of equal value at the time of deposit. For example, I might want to provide BNB USDT liquidity to a pool. If the amount I want to deposit into the pool is $500, I will deposit $250 worth of BNB and $250 USDT.
LPs use an automated market-making algorithm (AMM) working in the background to maintain the asset pair’s price-volume balance. This is implemented to minimize price deviations during trading. This algorithm introduces an opportunity cost of providing liquidity, called impermanent loss (IL).
Liquidity providers earn rewards by taking a percentage of transaction fees. Some platforms also reward liquidity providers with either the platform’s native tokens or with tokens from other projects. The latter case is referred to as liquidity mining. Providing liquidity to a platform and receiving any form of rewards is known as yield farming.
When a pool of liquidity is in place, a trader is essentially trading with the pool and not directly with another trader as with order book systems.
Popular examples of DeFi platforms with liquidity pools are Uniswap, Pancakeswap, Sushiswap, etc.
Risks Associated with Liquidity Pools
Liquidity pools, like most DeFi projects, rely on smart contracts. As such, they are vulnerable to traditional smart contract risks such as flaws in software code and malicious exploits by hackers. Although most DeFi projects now hire specialists to review their smart contract codes, exploits still occasionally occur.
Another type of risk that DeFi often poses is temporary losses. This is a loss that occurs when the price of the assets that an investor contributes to the pool changes from the price at the time of deposit. One way to avoid this loss is to invest in stablecoin liquidity pools. Stablecoin prices will remain relatively stablecoins throughout. Here is more explanation of temporary loss.
Another potential risk that is becoming more common is what is known as liquidity siphoning, or “carpet pulling” as it is called in the DeFi community. This happens when malicious people present a project as legitimate when they have fraudulent intentions. After gaining investor confidence for a while, they quickly drain the pool of liquidity and disappear. This is a warning to investors not to just throw their money into whatever project comes to mind. Make sure you do due diligence and research on the project team.
Final Thoughts on Liquidity Pools
The rapid growth of decentralized finance is largely due to the services provided by DeFi. Many of these services are possible because of the role that liquidity pools play in DeFi. Although there are risks associated with liquidity pools, steps can be taken to minimize these.
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