Cryptonomics: What are Liquidity Pools in Decentralized Finance

The financial freedom and control that decentralized finance offers users has led to a rapid growth of the DeFi sector. Liquidity pools and automated market makers (AMMs) are a major reason why DeFi has so much utility.

By
Ahamdi Abarikwu
on
April 4, 2021
Category:
Cryptonomics

Introduction

It is easy to understand why decentralized finance (DeFi) is experiencing a great boom. The advantages that DeFi brings are in tune with the desires of many people. Lots of people want to have the freedom to do what they wish 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 issues alongside many more have been solved through DeFi. DeFi has become such a rapidly growing trend because of the sense of financial freedom and control that it offers. 

DeFi cannot run on the structure of centralized systems. Thus, for it to break away from centralization, it meant that new frameworks that will drive it would be needed. There are a number of structures that power DeFi in the background to provide the services we all enjoy. One of such structures is what is known as Liquidity Pools. Let us explain in simple terms what Liquidity Pools are all about. 

What Is Liquidity? 

It is necessary to know what liquidity is, before proceeding to talk about pools. In very simple terms, liquidity refers to the amount of money available for settlement. It describes how easy it is to convert an asset from one form to another. Before the advent of crypto, it meant how easy it is to sell an asset in return for cash. Now in terms of crypto, it refers to how easy it is to exchange a particular crypto asset for another. 

For it to be easy to convert from one crypto token to another, there needs to be a sufficient amount of the tokens in question. This will ensure that requests from users will be met regardless of the volume demanded. Additionally, it ensures that there will be minimal difference in price because demand is always balanced by supply.

Another key requirement is time. Systems that have poor liquidity do not have sufficient volume to meet users’ needs. It means that there could be delays in settlement if the volume demanded is more than available liquidity.

From the foregoing, we can see that an exchange needs to have good/high liquidity. If it does not, its users will have a very poor trading experience.

Decentralized exchanges (DEXs) must have high liquidity. One of the goals of decentralized finance is to give users a better experience than that of centralized exchanges, which have tons of liquidity.


What then is a Liquidity Pool?

It simply is a pair of crypto assets. This pair is locked by a smart contract. It forms an aggregated store of assets pooled together by investors. Liquidity Pools are DeFi’s backbone; without them, DeFi wouldn’t be able to offer financial services to people. 

Why Are Liquidity Pools Important In Decentralized Finance? 

LPs are a very critical support structure for DeFi. Here are several reasons why they are so important. 

  1. They help to ensure that there is always sufficient liquidity in the system to match orders at all times. Traders do not have to look for who to buy from or who to sell to.
  2. It guarantees fast transaction time. 
  3. Decentralization

Liquidity pools provide a path through which a DeFi platform can be governed. High liquidity in a DeFi platform gives people confidence in the platform. Providers of liquidity in the platform are often given governance rights through utility tokens. These tokens are given as liquidity incentives and allow users to propose changes and improvements to the platform. 

Features of Liquidity Pools. 

  1. Virtually Stress-Free

With LP a trader does not need to have his eyes fixed on order books watching charts, nor tracking prices. He simply goes to the LP platform and transacts without undue stress. 

  1. They are truly decentralized. 

Centralized exchanges with their order books were a helpful beginning in the earlier days of crypto. The problem with them is their centralized operation. You usually need to give up personal information via KYC. Sometimes you may not be able to do transactions because of the country you are from, or because your funds are not up to the minimum specified by the CEX for a trade. These barriers to financial freedom do not exist with platforms running on Liquidity Pools.

  1. Lower Transaction Fees

Generally speaking, LP platforms have lower gas costs compared to their centralized counterparts. This is mainly due to efficiencies in the design of smart contracts used in LP platforms.

How Does A Liquidity Pool Work?

The 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 is required to deposit into the pool the two crypto assets. The amount of the two assets must have equal value at the point of being deposited. For example, I might want to provide BNB-USDT liquidity to a pool. If the amount I want to commit to the pool is $500, I will deposit $250 worth of BNB and $250 worth of USDT. 

LP’s utilize an automated market-making (AMM) algorithm that works behind the scene to maintain the asset-pair’s price-volume balance. This is implemented to minimize price deviations during trades. This algorithm introduces an opportunity cost of providing liquidity, coined impermanent loss (IL).

Liquidity providers earn rewards by getting a percentage of the transaction fees. Some platforms also reward liquidity providers with either the platform’s native tokens or tokens of other projects. The latter case is referred to as liquidity mining. Providing liquidity to a platform and receiving any form of rewards is referred to as yield farming.

With a liquidity pool in place, a trader essentially trades with the pool rather than directly with another trader like in order-book systems.

Popular examples of DeFi platforms that have liquidity pools are Uniswap, Pancakeswap, Sushiswap, etc. 

Risks Associated with Liquidity Pools

Liquidity Pools depend on smart contracts like most DeFi projects. Hence they are prone to traditional smart-contract risks like bugs in software codes and malicious exploits by hackers. Though most DeFi projects now engage specialists to audit their smart contract codes, occasionally exploits still do happen.

Another kind of risks common to DeFi is impermanent loss. This is a loss incurred when the price of the assets an investor deposits into the pool changes from what their price was at the time of deposit. One way of trying to avoid this loss is by investing in stablecoin-liquidity pools. The prices of the stablecoins will remain relatively stablecoins throughout. Here is more explanation of impermanent loss. 


Another potential risk that is becoming more common, is what is called Liquidity Siphoning or “rug-pulling” as it is known in the DeFi community. It happens when malicious persons present a project as legitimate whereas they have fraudulent intent. After a while of gaining the confidence of investors, they quickly withdraw the liquidity in the pool and disappear. This is a warning as an investor to not just put your money into any random project you see. Ensure you carry out due diligence and research on the project team. 

Closing Thoughts

The rapid growth of decentralized finance is largely due to the services that DeFi provides. A lot of these services are possible because of the role that liquidity pools play in DeFi. Though there are risks associated with liquidity pools, there are measures that could be taken to help reduce them to the barest. 

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Ahamdi Abarikwu

Ahamdi Abarikwu is an Electrical Engineer and a lover of anything crypto. He is also an avid writer, proofreader and editor. He loves to play Scrabble in his spare time.

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