What is a Liquidity Pool in Cryptocurrency?

What is a Liquidity Pool in Cryptocurrency?

Liquidity pools allow users to purchase and sell cryptocurrency on decentralized exchange platforms and other DeFi platforms without a centralized market maker. They are one of the foundational technologies behind the DeFi ecosystem and an eminent part of automated market makers, yield farming, 

borrow-lend protocols, on-chain insurance, synthetic assets, blockchain gaming – the list goes on.

A liquidity pool is, in fact, a crowdsourced pool of cryptos or tokens locked in smart contracts that facilitates trades among the assets on a DEX (decentralized exchange). Many DeFi platforms use AMMs (automated market makers), which let digital currency trades happen in an automatic and permissionless way through liquidity pools.

The idea is pretty simple since a liquidity pool is funds thrown together in a digital pile. But the question is this: What can we do with this pile in a permissionless system, where everyone can add liquidity to it? 

Decentralized Finance has made a blast of on-chain activity. DEX volumes can expressively compete with the volume on centralized exchanges. There were almost 15 billion dollars locked in DeFi protocols in 2020. The ecosystem is promptly expanding with new kinds of products. What makes this expansion possible? One of the critical technologies behind all these products is the liquidity pool. In the following sections, you will learn all you need to know.

liquidity pool

What is liquidity?

The term liquidity in crypto shows how easy it is to convert a crypto asset into fiat money and swap one asset for another. Liquidity is crucial for all operations in Decentralized Finances, like lending or borrowing and token swaps.

Low liquidity levels for a particular token result in volatility, prompting severe fluctuations in that cryptocurrency’s swap rates. On the other hand, high liquidity means that heavy price swings for a token are less probable.

What is a liquidity pool?

A liquidity pool is a collection of assets locked in a smart contract. These pools facilitate decentralized trading, lending, and other roles we will explore later.

Liquidity pools are the Foundations of many DEXs. Users called LP (liquidity providers) can add an equal worth of two tokens in a pool to create a market. LPs provide the funds; therefore, they earn trading fees from the trades in their pool, proportional to their share of the total liquidity. AMMs have made the market more available, so now anyone can be an LP.

Liquidity pools in the protocols that offer liquidity pools also may contain ERC-20 tokens and or BEP-20 tokens. 

centralized exchanges 

Centralized exchange platforms (in crypto) that implement an order book system handle almost all centralization problems in traditional Finance. This can make them unappealing. Nevertheless, decentralized order books are expensive to implement on a blockchain. 

There is an alternative to providing liquidity is by using a market maker. A market maker is an agent who is ready to purchase and sell particular assets at any time, thus providing liquidity to the market. 

DeFi ecosystems replace a centralized market maker with a decentralized counterpart. With this said DEX ) decentralized exchanges are here to replace centralized exchange platforms.

Crypto Liquidity Pools in DeFi

Crypto liquidity pools are essential in the DeFi (decentralized Finance) ecosystem, especially in DEXs (decentralized exchanges). Liquidity pools are a tool by which users can pool their funds in a DEX’s smart contracts to offer asset liquidity for traders to swap between currencies. crypto pools present speed, much-needed liquidity, and convenience to the DeFi ecosystem.

Before introducing automated market makers (AMM), crypto market liquidity was a problem for DEXs on Ethereum. DEXs were a new technology with a complex interface. There were not many buyers and sellers then, so it was challenging to find enough users willing to trade regularly. AMMs fix this issue of limited liquidity by making liquidity pools and offering liquidity providers the enticement to supply these pools with assets, all without the need for third-party involvement. The more assets and the more liquidity the pool has, the easier trading becomes on DEXs.

liquidity pool

How Do Crypto Pools Work?

An operational crypto liquidity pool has to attract crypto liquidity providers to stake their crypto in a pool. That is why most liquidity providers get trading fees and crypto rewards from the exchange platforms. Once a user supplies a pool with liquidity, the provider often receives a reward (LP tokens). LP tokens can be valued assets in their own right and the DeFi ecosystem differently.

Usually, a crypto liquidity provider earns LP tokens according to the pool’s amount of liquidity they have funded. A small fee is proportionally distributed amongst the LP holders when a pool facilitates a trade. For the liquidity provider to earn back the liquidity they contributed (in addition to accrued fees from their portion), their LP tokens have to be destroyed.

Liquidity pools keep fair market values for the tokens they hold through AMM algorithms, which conserve the price relative to one another within any specific pool. Liquidity pools in different protocols might use algorithms that are a bit different. For example, one crypto pool might use a constant product formula to maintain price ratios, and many DEX platforms use a similar model. This algorithm helps a pool provide crypto market liquidity by handling the cost and ratio of the corresponding tokens as the demanded quantity growth.

The importance of Automated market makers

AMMs (Automated market makers) have altered this game. They are a significant innovation and provide on-chain trading without an order book. Traders can sell and buy positions on token pairs that would probably be highly illiquid on order book exchanges since there is no need for a direct counterparty to execute trades.

You can think of an order book exchange platform as (P2P) peer-to-peer, where the order book connects buyers and sellers. Trading by an AMM is different; think of it as peer-to-contract.

A liquidity pool gathers funds placed into a smart contract by liquidity providers. When making a trade on an AMM, you do not have a counterparty in the traditional sense. Instead, you are making the trade against the liquidity pool’s liquidity.

If you are a buyer, you do not need to find or wait for a seller at that specific time. You only need enough liquidity in the pool. When there is no seller, the algorithm manages your purchase in the pool. This algorithm that governs the trades determines the prices.

Yield Farming and Liquidity Pools

Suppose one wishes to have a better trading experience. In that case, various protocols motivate users to offer liquidity by providing more tokens for specific “incentivized” pools. You can use these incentivized liquidity pools as a provider to earn the maximum amount of LP tokens (liquidity mining). Liquidity mining is how crypto exchange LPs can optimize their LP token earnings on a particular market or platform.

Various DeFi markets, platforms, and incentivized pools let you earn rewards for providing and mining liquidity through LP tokens. So how does a crypto liquidity provider select where to put their funds? 

Yield farming is staking or locking cryptos inside a blockchain protocol to create tokenized rewards. It is staking or locking up tokens in various DeFi applications to generate tokenized rewards that maximize earnings. As a result, This lets a crypto exchange liquidity provider collect high returns for somewhat higher risk as the algorithm distributes their funds to trading pairs and incentivized pools with the highest trading fee and LP token payouts in multiple platforms. This kind of liquidity investing can inevitably put a user’s funds into the highest yielding asset pairs. 

The Value of Crypto Liquidity Pools

In the early days of DeFi, Decentralized Exchanges suffered from crypto market liquidity issues when trying to model the traditional market makers. 

Liquidity pools helped resolve this problem by motivating users to provide liquidity instead of matching a buyer and seller in an order book. This brought a powerful, decentralized solution to liquidity in Decentralized Finances and contributed to unlocking the growth of the DeFi sector. Liquidity pools might have been born from necessity. Nonetheless, their innovation brings a new way to offer decentralized liquidity algorithmically. It provides this liquidity via incentivized, user-funded pools of asset pairs.

The importance of Liquidity Pool

Like the conventional stock exchange platforms, Centralized exchanges follow the Order Book model, allowing buyers and sellers to place orders. In the Order Book model, buyers aim to buy an asset at the lowest possible price. In contrast, sellers focus on selling the asset at the maximum possible price.

At this point, the seller and the buyer should agree on the price for a successful trade. On the other hand, you might face some setbacks when the seller and the buyer cannot agree on the price. Moreover, liquidity also brings forth obstacles in executing the trade. Market Makers find a perfect chance in this case and safeguard trading by placing commitments for purchasing or selling a particular asset. As a result, they could provide liquidity.

Besides offering liquidity, Market Makers can also help traders manage transactions without waiting for other sellers or buyers. Although, relying excessively on external market makers can lead to extremely slow and expensive transactions. The concept of liquidity pools in Decentralized Finances may play a conclusive role in addressing these problems. 

Why you should use a pool?

Any experienced trader in traditional or crypto markets can tell you about the possible disadvantages of entering a market with little liquidity. Whether it is a low-cap cryptocurrency or penny stock, Slippage will be an issue when taking any trade. Whenever there is a difference between the expected price and the actual price of a trade, it is called Slippage. Slippage usually happens during periods of higher volatility. It can also occur when a large order is due, but there is not enough volume at the selected price to keep the bid-ask spread.

Liquidity pools try to solve the problem of illiquid markets by motivating users to provide crypto liquidity for a share of trading fees. Users can exchange their assets using liquidity that other users provide.

Bitcoin Symbol Logo Currency Digital Money

The disadvantages of liquidity pools

If you provide liquidity to an AMM, you must know about impermanent loss. In short, it is a loss in dollar value compared to holding when you are giving liquidity to an AMM.

If you do so, you are probably at risk for impermanent loss. Sometimes it can be little; sometimes, it can be huge. 

Another thing you would better be aware of is smart contract risks. When you put funds in a liquidity pool, technically, no middlemen hold your funds. The contract itself can be the custodian of those funds. For instance, if there is a bug or some exploit through a flash loan, you may lose your funds forever.

Correspondingly, be cautious of projects where the developers can change the rules governing the pool. Sometimes, developers can have an administrative key or other privileged access in the smart contract code. This can let them potentially do something hateful, like controlling the funds in the pool. 

Are crypto pools safe?

Liquidity pools are key technologies behind the current Decentralized Finance technology stack. They enable decentralized trading, yield generation, lending, and much more. These smart contracts power nearly every part of DeFi, and they will probably continue to do so.

But when it comes to assessing the safety of a liquidity pool, you have to bear in mind that, like any other investment, this one also has its risks while it could be profitable. Suppose you wish to learn more about investment in crypto and other cryptocurrency-related subjects. In that case, you can check out other articles on the Bitunivex website.

Bitunivex, a fiat and crypto exchange in Australia, will try its best to answer your questions and help educate you in the cryptocurrency investment fields.

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