How Do Liquidity Pools Work?

Decentralized Finance (DeFi) is changing how most people perceive finance. It is giving us a new way to look at how we can bring this important traditional market into the crypto industry.

One of the best things to come out of DeFi so far is the concept of a Liquidity Pool (LP). And that is what this article is going to be all about.

Now, a lot of you might already be familiar with LPs. So here’s a quick rundown of everything we’re going to talk about in the article. If you know about LPs and don’t want to read about them again, feel free to jump to the section that interests you!

  1. The Relevance of Liquidity
  2. What are Liquidity Pools in DeFi?
  3. Poor Liquidity is a Risk
  4. How Do Liquidity Pools Work?
  5. How to Participate in a Liquidity Pool?
  6. How Do Liquidity Pool Exchanges Work?
  7. Advantages of Liquidity Pools
  8. Liquidity Pool Returns
  9. Liquidity Pool Risks
  10. Liquidity Pool Token and Yield Farming
  11. Leading Liquidity Pool Providers
Liquidity Pools

The Relevance of Liquidity

Basically, liquidity refers to the ease with which an asset can be exchanged for cash without affecting the price of that asset. The main reason liquidity is so important is that it largely determines how an asset’s price can shift.

A relatively limited number of open orders are open on all sides of the order book in a low liquidity market.

This suggests that one transaction could shift the price in any direction significantly, making the cryptocurrencies unpredictable and unattractive.

Liquidity pools are an integral part of the Decentralized Finance (DeFi) revolution and they seem to show real promise. These pools are typically able to promote the exchange of a significant number of assets with any other supported asset.

They apply to the pool of tokens locked in the smart contract. By offering liquidity, they guarantee trade and are used widely by some of the decentralized exchanges. Bancor made one of the first initiatives to incorporate liquidity pools, and Uniswap made it widely popular. Their job is to improve the liquidity of the market for market participants. 

So, what exactly is a liquidity pool? How does it work? Let’s peel the layers one by one.

What are Liquidity Pools in DeFi?

Liquidity pools aim to address the low liquidity problem successfully and thus guarantee that the price of a token does not swing significantly after performing the order of a single large trade.

Decentralized exchanges offer bonuses to those who invest in the liquidity pools in order to maximize customer engagement. The user has to deposit money into the liquidity pool to engage and reap the benefits.

For various DeFi platforms, the number of assets which need to be deposited and the proportionate ratio of each token can vary. One of the first projects that introduced liquidity pools was Bancor, but they became widely popularised by Uniswap.

What is low liquidity? Is it a risk? How does it affect the market? Let us understand in depth.

Poor Liquidity is a Risk

Essentially, low liquidity markets are very much vulnerable. Drastic changes can be triggered by one slight shift from one direction. This scares major players off because it places their money at higher risk. It is better to just ignore the market entirely, instead of taking a chance.

Owing to the emerging nature of the market, massive volumes of digital assets, and far more trade pairs, cryptocurrencies struggle in particular from liquidity problems. The current market conditions fit liquidity into exchanges and trading pairs, limiting the liquidity open to traders even further.

How much Bitcoin liquidity is out there doesn’t matter because it’s divided between thousands of exchanges and heaps of trading pairs.

How Do Liquidity Pools Work?

In its simplest form, a single liquidity pool contains 2 tokens and each pool establishes a new market for the same pair of tokens. A good example of a popular liquidity pool on Uniswap could be DAI / ETH.

The first liquidity provider when a new pool is formed is the one that determines the initial price of the assets in the pool. The liquidity provider is encouraged to provide to the pool an equivalent value of all tokens.

When liquidity is supplied to a pool, special tokens called LP tokens are received by the liquidity provider (LP) in proportion to how much liquidity they supply to the pool. A 0.3 % cost is proportionally distributed to all LP token holders when a sale is enabled by the pool.

They would burn their LP tokens if the liquidity provider wishes to get their underlying liquidity back, with any unpaid fees. Each token swap facilitated by a liquidity pool results in a price change according to a deterministic pricing algorithm. This process is also called automatic market-making.

By now you understand how liquidity pools work, and you would probably be interested in participating in a liquidity pool. Let’s talk about how one can participate in the pool.

How to Participate in a Liquidity Pool?

Liquidity pools are built to perform trades and maintain pricing according to a constant product formula that ensures the value of each reserve stays constant even as the ratios of the assets change.

Buy transactions increase the price of the bought asset relative to the sold asset and sell transactions decrease the price of the sold asset (since its ratio in the pool increases.

Let’s understand this with an example:

It takes a deposit of $50 worth of ETH and $50 USDC to deliver $50 of liquidity into an ETH / USDC pool. In this case, a total deposit of $100 is needed.

The liquid provider will receive liquidity pool tokens in return. Such tokens reflect their proportional pool share and allow them to withdraw their pool share at any time.

A trading fee is deducted from the transaction anytime a seller makes a transaction, and the order is sent to the smart contract holding the liquidity pool. The trading fee is set at 0.3% for most decentralized exchanges.

In our case, if you deposit $50 ETH and $50 USDC and you make up 1 % of the pool with your donation. You will receive 1 % of the 0.3 % trading fee for any particular trade.

How Do Liquidity Pool Exchanges Work?

To explain liquidity pools, one has to understand a more basic form of trading mechanism: order book trading and Liquidity pools Exchanges.

1. Order Book Exchanges

The order book exchanges depend on a bid /ask scheme to complete transactions.

Orders get redirected to an order book when a new buy or sale order is made. Then the matching engine of the exchange executes matching orders for the same price.

Example: 0x and Radar Relay

2. Liquidity Pools Exchanges

A liquidity pool refers to a pool of tokens from users that are locked in smart contracts.

Liquidity pools were designed to address and rectify this problem and to offer liquidity at different price levels. They exclude emphasis on order book dealing from the exchange. Thus they enable the exchange to ensure the liquidity level is steady.

 Example: Kyber, Uniswap, and Curve Finance

Advantages of Liquidity Pools

1. Guaranteed liquidity at every price level: Basically,  a liquidity pool is just an automated market maker in the form of a smart contract that automatically matches traders’ buy and sell orders based on predefined parameters.

Here, Traders do not need to be directly associated with other traders, so liquidity is constant as long as investors have deposited assets into the pool. Moreover, trades with large liquidity can still suffer from significant slippage

2. Automated pricing enables passive market making: To assess the price of assets, liquidity pools don’t need to integrate information across exchanges. Liquidity providers actually deposit their funds into the pool and pricing is taken care of by the smart contract.

3. Anyone can become a liquidity provider and earn: No listing fees, KYCs, or other barriers associated with centralized exchanges are required for liquidity pools. If an investor wants to provide liquidity to the pool, they will deposit an equivalent value of the assets.

For example, Uniswap charges a 0.3% trade fee. If your $100 ETH/DAI contribution makes up 0.007% of the pool, you’ll get 0.007% of that 0.3% trading fee.

4. Lower gas fees: The gas costs are reduced due to the minimal smart contract design offered by the decentralized exchanges like Uniswap. Effective price calculations and fee allocations within the pool imply less volatility between transactions.

Liquidity Pool Returns

The returns from the liquidity pool depend on three factors:

  • The asset prices when delivered and withdrawn
  • The size of the liquidity pool
  • The trading volumes

It is very important to note that investors will likely end up withdrawing a different ratio of assets compared to what they first deposited.

This is because trading activity can change the price and quantity of assets in the pool. This is where the market movement can either work for or against.

Liquidity Pool Risks

And of course, like with everything in DeFi we have to remember about potential risks. some of the liquidity risks associated are listed below:

Liquidity Pool Token and Yield Farming

Yield farming is a method used to maximize return on investment by investors in DeFi, using various products in the DeFi ecosystem. While there are numerous methods to optimize returns using yield farming, the most popular approach is to use the liquidity tokens given by the DeFi platforms.

Like all other tokens, a user can use the liquidity pool tokens during the period of the smart contract. A user can therefore deposit this token on a different platform that accepts the liquidity pool token in order to get additional yield to maximize the return.

Therefore, the user can compound two or three interest rates by using yield farming and eventually increase the returns.

Leading Liquidity Pool Providers

1. Uniswap

Uniswap Liquidity pool gathers tokens in a smart contract model, and users trade in the liquidity pool. On this platform, you can easily add tokens or swap tokens to a pool in order to earn some fees.

The best thing about the Uniswap platform is that you can easily exchange Ethereum for any ERC-20 token.

This exchange happens in a decentralized manner. You are not dealing with any company, there is no KYC involved.

2. Bancor

When you add liquidity to a Bancor pool, you receive pool tokens in proportion to the number of assets you’ve added to the pool.

Bancor pool tokens can accrue value in three ways:

  • Trading fees generated by the pool
  • Pool rewards provided by a token project via liquidity provider incentive programs
  • Pool rewards provided by the Bancor Protocol via BNT inflation

There are now numerous interfaces where you can add and remove liquidity from Bancor pools, track profits, and analyze the best-performing pools on the network.

3. Just Swap

TRON made its first foray into the DeFi industry with the release of the TRON-powered stablecoin lending platform—JUST.

JustSwap is a shared exchange protocol built for the automatic provision of liquidity. It provides a transparent financial market available to all.

Currently, few DEXs provide these features wherein they allow users to exchange tokens for any pairing with no slippage or late trades.

Before You Go…

Liquidity pools are one of the best things that the DeFi revolution gave us.

It has helped improve decentralization in the DeFi space and has made it more efficient. More than anything, it has made finance more accessible for everyone in the blockchain industry.

And the best part is that people are still working on improving it and making it more secure. So, while we can’t say for sure what the future holds in store for liquidity pools, I’m sure it’s something good.

That said, this article was only meant to educate you about liquidity pools. To put your money in one is at your own discretion. So invest only when you know you’re doing it right!