In this article, we will explain what liquidity pools are, how they work, and their role in the DeFi ecosystem. We’ll also cover a few advantages of liquidity pools and the differences between some of today’s most popular liquidity pool exchanges.
What Are Liquidity Pools?
Liquidity pools are one of the core technologies behind today’s DeFi ecosystem, being an essential part of Automated Market Makers (AMMs), yield farming, and borrow-lend protocols, to name just a few DeFi areas.
A liquidity pool is, in essence, a collection of funds that are locked in a smart contract. They are used to facilitate a variety of functions, such as trading and lending, and stand as the backbone of many Decentralized Exchanges (DEXs).
Before we dive deeper into the mechanism behind liquidity pools and automated market makers, though, let’s see why we need them in the first place.
Why Do We Need Liquidity Pools?
There are currently two types of DEXs on Ethereum, namely order book peer-to-peer exchanges, such as Radar Relay, and liquidity pool exchanges, such as Bancor and Uniswap.
The most commonly-used trading mechanism implemented by crypto exchanges is order book trading, which is used to match buyers and sellers and relies on a bid/ask system.
In order book trading, buyers and sellers place an order at their chosen price for a token, with buyers placing buy orders and sellers placing sell orders. While buyers try to buy an asset at the lowest price possible, sellers try to sell it for as high as possible. In order for the trade to occur, both the buyer and the seller have to agree on the price.
A matching engine will then match an opposite order for the price offered. It will execute and fill the trade only when such an order is available.
In order book trading, there are usually two types of traders:
- Takers or the traders who take the bid/ask price that is already in the order book.
- Market makers or the traders who place orders for prices that are not currently available in the order books. They are the ones who provide liquidity and enable traders to trade without waiting for another buyer or seller to show up.
While this type of trading usually works well when there are enough buyers and sellers in the market and for coins with high demand and liquidity, it may not be the best choice for tokens that lack liquidity due to low interest or volume. Such tokens may not only become difficult to sell/buy but may also be affected by unpredictable price swings as a result of large individual transactions.
As a consequence, it is less likely for tokens characterized by high volatility and inefficient conversions to be adopted. In DeFi, depending excessively on external market makers may lead to relatively slow and expensive transactions.
Here is where Automated Market Makers (AMM) and liquidity pools come in. AMMs have changed this game as they have no need for order books. Instead, they use smart contracts to form liquidity pools that automatically execute trades based on certain pre-defined parameters. Liquidity pools thus remove the tokens’ dependence on trade volume and ensure constant liquidity at different price levels.
But how do liquidity pools work?
A basic liquidity pool holds two tokens and creates a market for that specific pair of tokens on a DEX. An example of a popular pair is DAI/ETH. The first liquidity provider (LP) is the one to set the initial price of the assets in the newly created pool and add an equal value of the two tokens. For example, you can start with $10 of DAI and $10 of ETH.
So, people can now trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool. This further means the liquidity pool allows traders to trade against those funds 24/7.
The concept of an equal supply of both assets is the same for all the other liquidity providers who want to supply liquidity to the pool. Since anyone can be a liquidity provider – as long as they have the correct asset(s) for the platform of choice-, AMMs have made market-making significantly more accessible.
In exchange for providing their funds, liquidity providers earn special tokens called LP tokens, which are proportional to their share of the total liquidity. Whenever a trade is facilitated, a transaction fee is proportionally distributed among all Liquidity Providers.
In case a liquidity provider decides to get their underlying liquidity back, as well as any accrued fees, they must burn the LP tokens they hold.
The ratio of the tokens in the Liquidity Pool dictates the price of assets. So, for example, when you buy DAI from the DAI/ETH pool, the supply of DAI is reduced, while the supply of ETH is increased proportionally. This will further lead to an increase in the price of DAI and a decrease in the price of ETH.
It is important to note that larger pools have the advantage of accommodating bigger trades without the price of the asset moving too much. They create less slippage, thus ensuring a better trading experience.
Use Cases of Liquidity Pools
One of the most popular DeFi protocols used to exchange cryptocurrencies and that encourages the most basic forms of liquidity pools is Uniswap, a decentralized ETH and ERC-20 token exchange that charges a 0.3% trading fee on all its pools.
However, there are several other DEXs that rely on the core principle of liquidity pools but differentiate themselves when it comes to practical use cases, such as Bancor, Sushiswap, Curve, and Balancer.
After realizing that the concept behind Automated Market Makers doesn’t work as desired with stablecoins or wrapped tokens, Curve, an exchange liquidity pool on Ethereum, implemented a slightly different algorithm and now offers lower fees, as well as lower slippage.
Balancer also approached liquidity pools from a different standpoint, allowing for as many as 8 tokens in a single liquidity pool instead of the typical 2 assets.
Liquidity pools can be used in different ways, and one of the most common use cases is liquidity mining or yield farming through which liquidity providers are incentivized with extra tokens for supplying liquidity to certain pools.
Liquidity Pools – Risks & Advantages
When compared to the traditional order book model, liquidity pools come with four main advantages:
- They ensure constant liquidity at every price level.
- Automated pricing enables passive market making.
- Anyone can become a liquidity provider as long they have the correct asset(s) for the platform of choice.
- Reduced friction between transactions and lower gas fees.
However, the use of liquidity pools is not free of risks. Impermanent loss, smart contract bugs, systemic risks, and liquidity pool hacks are some of them, and we will explain them in the next videos.
To sum up, liquidity pools eliminate the need for a centralized order book and ensure constant liquidity. At the same time, they considerably reduce the dependence on external market makers to provide constant liquidity supply to DEXs.