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What are liquidity pools?

Learn what are liquidity pools and how liquidity pools work in our comprehensive guide liquidity pool explainer.

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Key Takeaways:
  • Liquidity pools are one of the fundamental technologies that power the current DeFi ecosystem.
  • Liquidity pools have a variety of applications including use in automated market makers, lending protocols, yield farming, synthetic assets, and on-chain insurance, to name a few. 
  • Anyone can become a liquidity provider by contributing equal portions of the two tokens included in the liquidity pool to earn a share of trading fees for that pool as a reward. 
  • The main liquidity pool risk involved is impermanent loss.

In the world of centralized finance (CeFi), well-funded individuals or firms known as market makers provide depth and liquidity to trading desks so that securities exchanges around the world can function in an orderly manner.

In decentralized finance (DeFi), rather than having a limited number of centralized entities providing liquidity in crypto and reaping the benefits, the process is opened to the community at large who can contribute their funds to liquidity pools that make up a key piece of what powers DeFi. 

If you’re still wondering, how do liquidity pools work? Here’s a closer look at what crypto liquidity pools are, how they function, and a deeper dive into their importance to the health of the DeFi ecosystem. 

Liquidity Pool Basics

A liquidity pool in crypto is a smart contract that holds a collection of funds that are contributed by various users in the DeFi community. The funds held in liquidity pools are used to facilitate activities in decentralized finance markets such as trading, lending and a variety of other functions. 

Popular decentralized exchanges such as Uniswap or PancakeSwap are only able to function thanks to DeFi liquidity pools and the users who contribute to them, who are known as liquidity providers (LPs).

The great thing about decentralized finance is that anyone can be a liquidity provider. To participate in a liquidity pool, LPs deposit an equal value of the two tokens, such as Ethereum and USDC, that comprise the pool to create a trading pair ETH/USDC. 

In return for providing liquidity to the pool, LPs receive a proportional share of the trading fees that come from that specific pool. Liquidity providers receive what’s known as liquidity pool token that represents their share of the crypto liquidity in the pool and function as a beacon for the smart contract to know where to send any earned fees or rewards. 

How do Liquidity Pools Work?

The introduction of automated market makers (AMMs) was a game-changer for the cryptocurrency ecosystem as made it possible to do on-chain trading without the need for order books, which are used to power traditional markets. 

With AMMs, the need for a direct counterparty to execute every exchange was eliminated thanks to the introduction of DeFi liquidity pools that facilitate around-the-clock trading. This was a significant development as it helped bring an increased level of liquidity for some tokens that are otherwise highly illiquid on exchange order books. 

Rather than trading in a peer-to-peer manner on traditional exchanges, AMMs can be better defined as a peer-to-contract trading environment that is governed by artificial intelligence. Trades that are conducted on a DeFi exchange pull from the funds deposited in that trading pair's liquidity pool, so all that is required to complete a transaction is for sufficient liquidity crypto to be deposited in the pool. 

Algorithms govern the price of each asset in the pool and quote prices based on the level of activity and the proportion of each asset currently held in the smart contract. 

Liquidity Pool Uses 

AMMs are the most popular use for liquidity pools in crypto, but they are but one of the many applications. Other situations where liquidity pools serve an important function include: 

  • Yield farming - Liquidity pools form the backbone of automated yield-generating platforms.
  • Liquidity mining - A way for a project or protocol to reward liquidity providers by distributing rewards based on the amount of liquidity pool tokens held or deposited by an LP. 
  • Governance - Liquidity pools can be used to collect the necessary number of votes to put forward a formal governance proposal. 
  • Insurance against smart contract risk - Pooled funds can act as an insurance fund. 
  • Tranching - A traditional finance concept where financial products are divided up based on their level of risk and reward, allowing LPs to design a customized liquidity pool risk/return profile. 
  • Minting synthetic assets - Minting new tokens that are a derivative of another asset requires some form of monetary backing to back its value. Funds deposited in a crypto liquidity pool can be used as the required collateral. 

Liquidity Pool Risks

The main liquidity pool risk involved in providing liquidity to an AMM is what’s known as impermanent loss. Simply stated, an impermanent loss is a loss in the dollar value of deposited funds when compared to simply holding the original assets. 

Since AMMs and crypto liquidity pools are designed to facilitate trade at any time, volatility and wild swings in the market can cause one of the tokens in a trading pair to see a dramatic change in price. As this occurs and traders sell the asset whose price is falling, they receive the paired token in exchange meaning that the liquidity provider now holds more of the depreciating asset. 

This can sometimes lead to holding a large amount of a token that has lost most of its value and may never potentially recover it, creating an impermanent loss until said tokens are sold and the loss becomes realized. 

On the flip side, the token may recover and the crypto liquidity pools can come out ahead if they continue to hold a greater proportion of the previously depreciated asset, which is why being an LP provider is a risk and reward scenario where there is a chance to experience loss. 

Another potential for loss that LPs need to be aware of are smart contract risks. While smart contracts eliminate the need for a trusted middleman that holds the funds, the contract itself can be considered the de facto custodian in control of the assets. If any exploits or bugs exist in the smart contract, it's possible that any deposited funds could be unable to be retrieved or stolen by hackers and lost forever. 

Along the same lines, it's also a good practice to steer clear of projects where developers have the ability to change the rules that govern a liquidity pool as this opens the possibility of a malicious inside attack where an individual party can take control of the funds in the pool. 

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