What Is A Liquidity Pool?

What is a Liquidity Pool - What Is A Liquidity Pool?

The present DeFi ecosystem is built on top of a number of core technologies, one of which being liquidity pools. They are a crucial component of automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, blockchain gaming, and many other blockchain-based applications.

The concept, by itself, is quite easy to understand. A liquidity pool is essentially just a large digital pile of cash that have been gathered together. But in a permissionless system in which anybody may add liquidity to it, what are some of the things that you can do with this pile?

Introduction

Decentralized Finance (DeFi) has created an explosion of on-chain activity. Volumes traded on decentralized exchanges are capable of substantially competing with those traded on controlled exchanges. By the end of the year 2020, there will be over 15 billion dollars’ worth of wealth locked up in decentralized finance protocols. The ecosystem is developing at a fast rate with the addition of new product categories.

But what is it that makes all of this growth feasible? The liquidity pool is one of the fundamental technology that underpins all of these different products.

What is a liquidity pool?

A pool of money that are kept secure by a digital contract is referred to as a liquidity pool. Liquidity pools are used to facilitate decentralized trading, lending, and many more functions we’ll explore later.

Many decentralized exchanges (DEX), like Uniswap, rely on liquidity pools as their primary trading mechanism. Users who are referred to as liquidity providers (LP) contribute an amount of two tokens with an identical value to a pool in order to establish a market. In return for contributing their cash, they are eligible to receive trading fees from any transactions that take place inside their pool. The amount of these fees is directly related to the fraction of the overall liquidity that they provide.

AMMs have made market making more approachable due to the fact that anybody may act as a liquidity provider.

Bancor was one of the first protocols to leverage liquidity pools, but Uniswap’s rise to popularity helped bring greater attention to the notion. SushiSwap, Curve, and Balancer are a few examples of further well-known exchanges that make use of liquidity pools on Ethereum. The venues in question use liquidity pools that hold ERC-20 tokens. PancakeSwap, BakerySwap, and BurgerSwap are similar alternatives that can be found on the Binance Smart Chain (BSC). The pools for each of these exchanges include BEP-20 tokens.

 Liquidity pools vs. order books

Let’s take a look at the order book, the most basic component of electronic trading, so we can have a better understanding of the differences between liquidity pools and order books. Simply put, the order book is a collection of the currently open orders for a given market.

The term “matching engine” refers to the computer program that pairs together individual orders with one another. The order book forms an integral part of the heart of any centralized exchange (CEX), together with the matching engine. This paradigm is fantastic for promoting efficient trading, and it was important in the development of sophisticated financial markets.

Trading decentralized financial instruments, on the other hand, entails carrying out transactions directly on the blockchain, without the involvement of a single, centralized authority. In terms of order books, this offers a challenging situation. Because there are gas expenses associated with each contact with the order book, it is much more difficult and costly to carry out transactions.

In addition to this, it makes the work of market makers, who are traders who offer liquidity for trading pairs, more expensive. First and foremost, the majority of blockchains are not capable of handling the necessary throughput for daily transactions involving billions of dollars.

Because of this, doing an on-chain order book exchange on a blockchain like Ethereum is almost unfeasible in its current state. You might make advantage of sidechains or layer-two solutions, both of which are currently under development. However, in its present configuration, the network is unable to adequately manage the traffic.
Before we move any further, it is important to point out that there are DEXs that operate normally with on-chain order books. This is something that should be noted.

The Binance DEX was developed on the Binance Chain platform, and its primary goals were to facilitate trading that is both quick and low cost. Another example is Project Serum being built on the Solana blockchain.

Even so, since much of the assets in the crypto space are on Ethereum, you can’t trade them on other networks unless you use some kind of cross-chain bridge.

Binance 10 - What Is A Liquidity Pool?

How do liquidity pools work?

Automated market makers (AMM) have changed this game. They are a key advancement that enables on-chain trading without the need of an order book. Because no direct counterparty is required to execute transactions, traders may enter and exit positions on token pairings that would be very illiquid on order book exchanges.

Consider an order book exchange to be peer-to-peer, with buyers and sellers linked through the order book. Trading on Binance DEX, for example, is peer-to-peer since transactions take place directly between user wallets.
Trading with an AMM is unique. Trading on an AMM may be seen of as peer-to-contract.

A liquidity pool, as previously stated, is a collection of cash placed into a smart contract by liquidity providers. When you execute a deal on an AMM, you do not have a typical counterparty. Instead, you are trading against the liquidity in the liquidity pool. There does not need to be a seller at that time for the buyer to purchase; just adequate liquidity in the pool is required.

When you purchase the newest food currency on Uniswap, there is no typical merchant on the opposite side. Instead, the algorithm that determines what occurs in the pool manages your activities. Furthermore, this algorithm determines price depending on transactions that occur in the pool. If you want to learn more about how this works, check out our AMM article.

Of course, the liquidity has to come somewhere, and anyone can be a liquidity provider, so they could be viewed as your counterparty in some sense. But, it’s not the same as in the case of the order book model, as you’re interacting with the contract that governs the pool.

What are liquidity pools used for?

So far, we’ve mainly spoken about AMMs, which have been the most prominent use of liquidity pools. However, as previously said, pooling liquidity is a fundamentally basic notion that may be used in a variety of ways.

One of them is yield farming, often known as liquidity mining. Users contribute their cash to liquidity pools, which are subsequently utilized to produce income on automated yield-generating platforms like Yearn.

Distributing fresh coins to the proper individuals is a challenging task for cryptocurrency initiatives. One of the most effective ways has been liquidity mining. To put it simply, tokens are awarded algorithmically to users that deposit their tokens in a liquidity pool. The freshly created tokens are then distributed in accordance to each user’s part in the pool.

Keep in mind that they might also be tokens from other liquidity pools known as pool tokens. For example, if you provide liquidity to Uniswap or lend cash to Compound, you will get tokens representing your portion of the pool. You may be able to invest those tokens in another pool and make a profit. These chains may get fairly intricate when protocols include pool tokens from other protocols into their products, and so on.

Governance might likewise be seen as a use case. In certain circumstances, a large number of token votes are required to put up a formal governance proposal. Instead, if the monies are pooled, members might rally around a shared cause that they believe is necessary for the protocol.

Insurance against smart contract risk is another burgeoning DeFi business. Liquidity pools are also used in several of its implementations.

Another, perhaps more cutting-edge, use of liquidity pools is tranching. It’s a classic finance concept that includes categorizing financial goods based on their risks and rewards. These products, as expected, enable LPs to set tailored risk and return profiles.
Liquidity pools are also used in the mining of synthetic assets on the blockchain. Connect some collateral to a liquidity pool and a trustworthy oracle, and you’ve got yourself a synthetic token pegged to any asset you choose. Okay, it’s a more sophisticated issue than that, but the underlying concept is this straightforward.

What else can we come up with? There are likely many more applications for liquidity pools that have yet to be discovered, and it is all up to the creativity of DeFi developers.

The risks of liquidity pools

If you provide liquidity to an AMM, you’ll need to be aware of a concept called impermanent loss. In short, it’s a loss in dollar value compared to HODLing when you’re providing liquidity to an AMM.
If you’re providing liquidity to an AMM, you’re probably exposed to impermanent loss. Sometimes it can be tiny; sometimes it can be huge. Make sure to read our article about it if you’re considering putting funds into a two-sided liquidity pool.
Another thing to keep in mind is smart contract risks. When you deposit funds into a liquidity pool, they are in the pool. So, while there are technically no middlemen holding your funds, the contract itself can be thought of as the custodian of those funds. If there is a bug or some kind of exploit through a flash loan, for example, your funds could be lost forever.
Also, be wary of projects where the developers have permission to change the rules governing the pool. Sometimes, developers can have an admin key or some other privileged access within the smart contract code. This can enable them to potentially do something malicious, like taking control of the funds in the pool. Read our DeFi scams article to try and avoid rug pulls and exit scams as best you can.

Closing thoughts

Liquidity pools are one of the core technologies behind the current DeFi technology stack. They make decentralized trade, lending, the creation of yields, and a lot of other things possible. These smart contracts are the driving force behind practically every aspect of DeFi, and it is quite probable that this will not change in the foreseeable future.

Last updated Sep 17, 2022

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