A Guide to Liquidity Pools - Simplifying DeFi for Beginners

In the early stages of DeFi, DEXs encountered crypto market liquidity issues when it tried to replicate traditional market makers. Liquidity pools addressed this issue by incentivizing users to offer liquidity rather than having a seller and buyer match in an order book. In this way, a robust, decentralized liquidity solution was created in DeFi, which played an important role in accelerating the sector's growth.

Presently, liquidity pools are one of the core technologies driving the present DeFi ecosystem.  They are a crucial aspect of yield farming, automated market makers (AMM), synthetic assets, on-chain insurance, borrow-lend protocols, blockchain gaming etc.

What is a liquidity pool?

A liquidity pool is a blockchain-based smart contract application that mimics a bank's process of paying interest in exchange for depositing assets.

Whenever traders enter a market, they rely on its liquidity. Without available liquidity, it is much more difficult to buy and sell assets, and either side may face unfavourable price conditions based on demand.

In the blockchain space, there are no institutions such as JP Morgan or Citadel Securities that operate as liquidity providers. Instead, Decentralized Finance (DeFi) generates liquidity through user participation. DeFi liquidity pools are specifically created via smart contracts.  

When you deposit your cryptocurrency funds into a DeFi liquidity pool, you effectively become both ends of a bank. Your funds are now locked into the liquidity pool and other traders can use them to trade cryptocurrencies between token pairs or to borrow.

As you may assume, when you lock your cryptocurrency funds into a liquidity pool, you become a liquidity provider (LP). Liquidity pools serve as yield farms and liquidity suppliers as yield farmers.

How do Liquidity pools work?

Ethereum based decentralized exchanges (DEXs) initially struggled with liquidity. As a new technology with a confusing interface, the number of purchasers and sellers was quite limited, and it was really hard to find enough people to trade on a regular basis. Automated Market Maker AMM, a financial technology, addresses the problem of low liquidity by setting up liquidity pools and incentivizing liquidity providers to provide these pools with assets.

Instead of trading between buyers and sellers, in AMM systems, users trade against a pool of tokens known as the liquidity pool. A crypto liquidity pool is essentially a shared fund of tokens. Users contribute tokens to liquidity pools, and a mathematical formula decides the pool's token price. Moreover, liquidity pools can be optimized for many reasons by changing the formula slightly.  

A DeFi liquidity pool stores two tokens in a smart contract to make a trading pair.  

We'll use Ether (ETH) and DAI Coin as examples; for convenience, let's suppose the price of ETH is 1000 DAI. Liquidity providers contribute an equal amount of ETH and DAI to this pool. Therefore, anyone putting in 1 ETH must match it with 1000 DAI. The liquidity in the pool symbolizes that when someone wishes to exchange ETH for DAI, they can do so by using the funds they have accumulated rather than relying on a counterparty to come along and match their order.  

Liquidity providers typically receive an amount for providing tokens to the pool. This cost is paid by traders who interact with the liquidity pool, similar to how transaction fees are charged when using a crypto credit card for digital purchases.  

For Example; ARMswap pays its liquidity providers double rewards of a share in swap fee to encourage participation from the users.

Liquidity Pools and Yield Farming

Some projects and protocols additionally provide additional incentives to LPs to maintain a big token pool, lowering the risk of slippages and enriching the user experience, resulting in a better trading experience. Liquidity mining is the practice of participating in incentivized liquidity pools as a provider to obtain the most LP tokens.  

Another option is yield farming, where users stake or tie up tokens in various DeFi applications to generate tokenized rewards. Crypto exchange liquidity providers can earn big returns for a bit higher risk by distributing their assets to trading pairs and incentivized pools with the highest trading fees and LP token rewards across various platforms. This type of liquidity investing can automatically allocate a user's cash to the greatest paying asset combinations. Yearn.finance, for example, automates balance risk choice and returns to shift your funds to various DeFi investments that provide liquidity.

Some Use cases of Liquidity pools

While governance is not a core function of liquidity pools, some DeFi protocols grant voting rights to liquidity providers through their LP tokens. This allows LP token holders to participate in governance decisions, aligning the interests of liquidity providers with the future direction of the protocol.  

Another emerging DeFi market is insurance against smart contract risk. Many of its applications are also backed by liquidity pools.

Another application of decentralized liquidity pools is tranching. It's a traditional finance concept that divides financial products according to their risks and returns. As one might assume, these products enable LPs to set bespoke risk and return profiles.  

Risks associated with liquidity pools

If you provide liquidity to an AMM, keep in mind that automated market makers, such as Uniswap, have challenges. Slippage is a phenomenon that many traders on low-liquidity trading pairs experience. Slippage is the gap between the expected and actual prices after the transaction is completed, which means that traders may lose value.  

Furthermore, the biggest risk that these pools face is that they are heavily automated. Attackers can execute large trades that manipulate asset prices within an AMM, leading to significant price imbalances and potential losses for other market participants. If the asset's price deviates significantly from the global market price, arbitrage traders will notice it very quickly, take advantage of the price variations across different platforms, and benefit from the discrepancy. Such price changes could impact liquidity providers, who may lose the value of their deposits. This is known as impermanent loss.  

Another issue to consider is the hazards associated with smart contracts. When you put funds into a liquidity pool, they remain in the pool. So, while there are no middlemen keeping your assets, the contract itself can be considered the custodian of those funds. If there is an error or any vulnerability in the smart contract, your funds may be gone forever.  

Also, be aware of projects where the developers can change the pool's regulations. Occasionally, developers may have an admin key or other privileged access to the smart contract functionality. This allows them to do something bad, such as take control of the pool's cash.  

Closing Thoughts

Crypto liquidity pools may have emerged out of need, but their invention introduces a novel approach to providing decentralized liquidity algorithmically via incentivized, user-funded pools of asset pairs.

Check out ARMswap’s liquidity pools and ways to get started with them.