What Are Liquidity Pools in DeFi? A Complete Guide to Understanding Liquidity Provision

At times, getting to know about bitcoin-world might seem like learning a new language. It's easy to get confused with phrases like "staking," "yield farming," and "AMM" and much more as these terms are used frequently. Similarly, you'll hear the term "liquidity pools" a lot too, particularly in the context of Decentralized Finance (DeFi).

However, what are they exactly? How do liquidity pools work? And why do they matter so much? 
 
This article will define liquidity pools, describe their basic operations, explore many different types, show you how to use and evaluate one, risks & benefits involved in liquidity pools, and their future outlook.

What Are Liquidity Pools?

A collection of money that is locked in a smart contract and available for lending or trading, is called a liquidity pool. 
 
For example, on a regular exchange, buyers and sellers must match orders. There must be another buyer willing to pay your price for one Ethereum if you wish to sell it. 
 
However, decentralized liquidity pools do not require that. People talk about “liquidity providers" instead of putting their cryptocurrency into a shared pool. After that other traders deal directly with the pool, and supply and demand cause the price to automatically change.

Liquidity Pools Explained Simply  

The idea is based on the fact that decentralized exchanges (DEXs) such as PancakeSwap and Uniswap do not use order books. They result in the use of AMMs, or automated market makers. 
 
Instead of trading against a matching engine, AMMs let users trade against a pool of tokens. As a result, you communicate with a smart contract that stores tokens rather than another trader.

• The liquidity pools help to make quick token swaps possible.
• Also, with it, it is easy to get rid of extra work for third parties.
• Provides us the Decentralized apps with power (dApps).
• It helps users to create passive income.
• Moreover, the liquidity pools are the backbone of the DeFi.
• Liquidity pools make trading instantly at any time.

How Does Liquidity Pool Work?

Let's use an example to walk through it step-by-step.

Let's say you sign up for an ETH/USDC pool on Uniswap. This means that:

• You deposit USDC and ETH in equal amounts.
• Your share is represented by LP (Liquidity Provider) tokens.
• You receive a share of the fees when users trade USDC and ETH through the pool.

The Formula

The AMMs typically use the constant product formula:

• x * y = k

Where:

• x = token A
• y = token B
• k = constant value (liquidity)

The pool is kept balanced by this formula. The price of ETH immediately increases when someone purchases it since there is less ETH and more USDC.

Types of Liquidity Pools

The Liquidity pool types vary from one another. In the DeFi ecosystem, various forms of liquidity pools have specific roles, just like different tools designed for different tasks. Some are designed for earning prizes, some are excellent for trading stablecoins, and some even facilitate borrowing and lending. 
 
Let's take a quick look at the main liquidity pool types found in DeFi, with a simple overview for everyone.

1. Constant Product Pools

This kind of liquidity pool is the most common and well-liked. The prices of the two tokens within these pools are automatically balanced using the simple mathematical formula mentioned above.

These pools automatically modify the token price whenever a trade is made, taking into account the quantity of each token in the pool. When someone purchases ETH, the pool contains less ETH and more USDC, which raises the price of ETH.

This type of pool is used by multiple DEXs (Decentralized Exchanges), including some of the best crypto liquidity providers like Uniswap and PancakeSwap. When trading tokens with frequent value fluctuations, it often performed well.

Pros

• Effective for the majority of trade pairs
• Easy to use and very common
• Simple to learn

Cons

• High slippage for large deals
• If prices fluctuate a much, one may experience temporary losses.

2. Stable Pools

These pools are specifically made for stablecoins, which are tokens that are meant to stay at or near $1, such as USDT, USDC, and DAI. 
 
In order to enable traders to exchange stablecoins with little slippage, stable pools employ a distinct type of formula. Slippage is the tiny discrepancy between a trade's actual price and its expected price. When trading huge amounts in regular pools, this can be significant. However, stable pools keep it extremely low, which is ideal for trading a lot of stablecoins.

These pools can be found on websites such as Curve Finance, which was created especially for trading stablecoins.

Pros

• Very little slippage
• Excellent for swapping stablecoins
• Reduced transient loss  

Cons

• Only stable tokens are allowed.
• Reduced yield in contrast to riskier pools
• Weighted Liquidity Pools

3. Weighted Liquidity Pools 

Two tokens of equal value, or 50/50, are usually stored in liquidity pools. Weighted pools, however, provide more flexibility. They can carry different tokens in different amounts. For instance, a pool might contain 60% ETH, 30% BTC, and 10% USDC.  

For tokens that aren't always equally significant or for individuals looking to create distinctive portfolios, this kind of pool is helpful.  

Platforms like Balancer, which provides weighted pools, allow users to create their own pools with different token percentages.  

Pros  

• Accepts more than two tokens.  
• Token weights that are easily adjustable  
• Beneficial for creating balanced portfolios.  

Cons

• More challenging to manage  
• Token dynamics require deeper comprehension.

4. Lending Liquidity Pools  

Lending pools operate very differently. Users lend their tokens to others and earn interest instead of trading them. The tokens can then be borrowed by other users, but interest will be charged.  

These pools are managed by smart contracts that automatically pair lenders and borrowers and handle repayments. You don't need to trust the borrower because the system handles everything.

Well-known platforms like Compound and Aave use lending pools.  

Pros

• Lending is a passive income source.  
• Get a cryptocurrency loan without having to liquidate your assets.  
• Fully managed through smart contracts.  

Cons  

• Bug risk in smart contracts  
• During price crashes, those who borrow money might be liquidated.

5. Incentives Liquidity Pools  

These are similar to conventional liquidity pools, but they offer extra advantages. In addition to trading fees for the liquidity providers, the platform offers native tokens like CAKE from PancakeSwap, ARMSP from ARMswap, and SUSHI from SushiSwap.  

These incentive pools are mostly used by new DeFi projects that are trying to attract customers. They can be very beneficial to early participants, but there may also be greater risks because the concept may be unstable or untested.  

Pros  

• Earn bonus tokens to earn extra cash.  
• Greater short-term returns  

Cons

• Often linked to more recent and detrimental projects  
• Token rewards may quickly depreciate.

Liquidity Pools Vs Yield Farming

You have probably heard the terms “liquidity pools” and “yield farming” and think they are the same.

But they are different and actually the smartest ways with which people are making their crypto work for them.

Plus Points of Liquidity Pools

Why would someone want to store cryptocurrency in a liquidity pool as opposed to just holding it in their hands?  

Let's look at the main benefits of deep liquidity in defi protocols that entice thousands of people to offer liquidity.

• Earning Passive Income  

One of the primary incentives for supplying liquidity is the creation of passive income. A tiny fee, typically around 0.3%, is paid each time a trade is made through the pool. Instead of going to a company, these fees are split among the people who provided the liquidity.  

Therefore, if you add your tokens to a liquidity pool, you will receive a portion of those trading fees. It's comparable to having your own small business and receiving payment each time users make a trade.

• Rewards and Yield Farming

Many DeFi networks offer liquidity providers incentives in the form of extra tokens. We call this yield farming, as explained above.

For example, if you provide liquidity on ARMswap, you could earn ARMSP tokens in addition to your trading fees. Sometimes, especially in more recent pools or user-attractive programs, these incentives can result in exceptionally high profits.

Payouts, however, are influenced by the platform and degree of pool competition.

• Market Efficiency

The foundation of decentralized exchanges (DEXs) is liquidity pools. A typical order book system that requires direct matching between customers and suppliers is no longer necessary. 
 
Liquidity pools allow you to quickly exchange one token for another, even if no one else is on the opposite side at that very moment. The market is now more efficient and faster, particularly for less well-known coins that would have trouble with a centralized exchange.

• Democratized Finance

Liquidity was restricted to large institutions or authorized brokers in conventional finance. However, the DeFi reverses the model. A liquidity pool is open to everyone, wherever in the world, without requiring authorization.

Everyday individuals may now engage, profit from, and contribute to the expansion of decentralized trading platforms without the assistance of a bank or other intermediary thanks to this democratized financial system.

Risks of Liquidity Pools

Liquidity pools have significant advantages, but there are also genuine risks. It's important to know about these risks if you're considering taking part so you can safeguard your cryptocurrency and make wiser choices.

• Impermanent Loss

In liquidity pools, this is the risk that is most misunderstood. When the value of one or both of the tokens in the pool alters dramatically after you have deposited them, you will experience an impermanent loss. 
 
Let’s say you put some ETH and CELO into the pool. Later, the price of ETH went up a lot.  

But the pool tries to keep a balance between ETH and CELO. So, it automatically adjusts the price of ETH against CELO. When you take your money out later, you’ll have more CELO but less ETH.

Even though you earned a bit from trading fees, you might have made more money if you had just held your ETH instead of putting it in the pool. This loss compared to just holding is called impermanent loss.

A Detailed Example for Better Understanding

Let’s say Ali adds 10 BNB and 1,000 CELO to a BNB/CELO liquidity pool.

At that time, 1 BNB equals 100 CELO, so both tokens are equal in value.

After one week:

• 100 traders used the pool
• Each trade had a 0.3% fee
• Ali owns 2% of the pool
• He earned $180 in swap fees

Now, BNB has gone up in price. It’s now worth 120 CELO instead of 100.

Because of that, Ali’s token amounts change. Liquidity pools always rebalance based on prices.

Now Ali has:

• 9.2 BNB
• 950 CELO
• Together, assume that’s worth about $6,500

If he didn’t join the pool and just held his tokens, he would have:

• 10 BNB + 1,000 CELO, potential worth $6,600

So, he made $180 in fees but lost $100 from the price movement (called impermanent loss).

In the end, he still gained $80 overall.

That’s how liquidity pools crypto work. You earn from trading fees, but price changes can affect your total value.

• Risk of Smart Contracts

Smart contracts, which are blockchain-stored automated code, power liquidity pools. If such programming has a flaw or vulnerability, hackers might take advantage of it and empty the entire pool. 
 
Even though the best DeFi platforms are audited, no code is completely secure. Make sure the platform you're utilizing is reputable and has undergone an audit by a third party which you can trust.

• Rug Pulls and Project Risk

You might know what liquidity pools are, but you must also know that not every project can be relied upon. In order to steal money, some developers make phony or dubious pools. After offering investors large returns, they "rug pull," which means they take away all liquidity and vanish with the money. 
 
This is more typical for tokens that are unknown or new. Extremely high return pools should be avoided since they might be too good to be true.

• Price Slippage

Slippage can result from massive trades that drastically alter the token price in pools with little liquidity. Therefore, during an exchange, you can receive less or pay more than you expected. Slippage can have an impact on the performance of the pool and your possible profits, even if it is not a direct risk for liquidity providers.

• High Gas Fees

Adding or withdrawing money from a liquidity pool on blockchains like Ethereum can be costly. Transaction fees for gas can vary from $20 to more than $100 during periods of network congestion. 
 
This makes it challenging for small investors to generate large profits, particularly if they often join and leave the pools.  

How to See Liquidity Pool of a Coin

It's a good idea to look at a token's liquidity pool before investing in it, it's similar to determining the depth before diving in.

Method 1: Use DEX Info Pages

Make use of the decentralized exchanges' official analytics pages.

Uniswap: info.uniswap.org

PancakeSwap is the website pancakeswap.info

SushiSwap: sushi.com/analytics

This method shows Pool size, Token price, Volume, and Fee earnings.

Method 2: DexScreener or DEXTools

In this method to see the coin's pool size and trade statistics, paste the contract address.

Method 3: Token trackers, such as Etherscan

In this method, the liquidity contracts are linked directly by certain explorers.

You can avoid scamming coins with low or phony liquidity by being able to verify pool data.

How to Use a Liquidity Pool (Step-by-Step with ARMswap)

Now that you understand what liquidity pools mean and how they work, let’s look at how to actually use one. We’ll use ARMswap, a cross-chain DEX designed for easy and safe token swaps across multiple different blockchain networks.

1: Connect Your Crypto Wallet

Head to the ARMswap platform and connect your Web3 wallet—like MetaMask.

Please make sure your wallet holds the tokens you want to deposit and that you’re on the correct network like Arbitrum or BNB Chain, etc.

2: Select a Pool

Reach to the “Liquidity” section and choose a token pair you’d like to provide. ARMswap offers a variety of decentralized liquidity pools like:

• ETH/BNB
• POL/ARB

Select one that matches your risk appetite and tokens you already hold.

3: Add Liquidity

Enter the amount of both tokens you wish to add to the pool. Approve both tokens and then confirm the liquidity deposit.

Once confirmed, you’ll receive ARMswap LP tokens in the connected wallet. They represent your share of the pool.

4: Earn Rewards

Now, just sit back and earn! Every time someone performs a swap in the pool you contributed to, you get a cut of the trading fees of the platform.

5: Withdraw When Ready

Whenever you want to exit, head back to the liquidity section, remove your share, and receive your original tokens—plus any earnings. Keep an eye on impermanent loss risk and monitor the pool's performance from your dashboard.

Best Practices for Using Liquidity Pools

If you are still wondering about how to invest in liquidity pools, continue reading the following steps.

1. Start small: If you're new, test it out with a small deposit first. Understand the mechanics before committing large amounts.
2. Pick stable pairs: Pairs like USDT/USDC or ETH/stETH tend to have lower impermanent loss. However, bitcoin liquidity pool is considered the most popular one.
3. Diversify: Don’t put all your crypto in one pool. Spread it out to balance your risk.
4. Watch gas-fees: On some expensive blockchains e.g Ethereum, transaction fees mostly eat up the earned profits. ARMswap supports multiple chains to help with this.
5. Know the platform: Fee structure varies on different DEXs, incentives, and risks. ARMswap is designed for cross-chain functionality and user-friendly liquidity tools.

Future Outlook of Liquidity Pools

Decentralized finance is growing and liquidity pools, being a part of it, are also evolving right along.

By the next few years, we are set to see big changes. Think smarter capital use, more rewards for liquidity providers, and better risk control. Exciting, right?

The future looks more advanced but also more user-friendly. Especially for anyone in the crypto space. Let us see what type of future developments we might expect in the crypto liquidity pools market:

• Omnichain Liquidity

Imagine this; you no longer need to stick to just one blockchain.

That is what omnichain liquidity is all about. It connects liquidity pools across multiple chains, making everything smoother and more powerful.

Traders and liquidity providers will be able to access or provide liquidity on different networks, all from one place to another. No more bouncing between platforms. Just simple, seamless access.

• AI-Powered Liquidity Pools

Here is where things get really smart.

Artificial intelligence is stepping in to take charge. It will track trends, predict market shifts, and adjust your liquidity positions in real time.

That means faster decisions. Better timing. And less guesswork for everyone in decentralized finance.

• Cross Chain Liquidity

Moving assets across chains used to be a pain. But that is changing fast.

As different blockchains become more connected, cross-chain liquidity pools will make swapping assets across networks much easier.

Less fragmentation. More efficient trades. And yes, new ways for liquidity providers to earn.

What Developments Can be seen in DeFi sector?

Decentralized finance is also not slowing down. It is pushing forward with fresh ideas and bold models.

We might see hybrid liquidity setups and even tokenized real-world assets (RWAs). These will open the door to more income streams for liquidity providers.

As decentralized finance starts to blend with traditional finance, things will only get more dynamic. Liquidity provision is about to become smarter, more inclusive, and much more profitable.

Summing Up

Decentralized finance (DeFi) is based on liquidity pools. They remove the need for conventional middlemen like banks and brokers, enable quick token swaps, and provide passive income generation for consumers.

Liquidity pools are shared cryptocurrency pools that are used for trading and profit-making and are secured by smart contracts. They allow anyone to contribute cryptocurrency to a pool, receive fees or prizes, and facilitate trading for others.

Learn about the many forms of liquidity pools (such as multi-asset versus stablecoin). Dex tools are used to check pool data. To calculate earnings and risks, use a liquidity pool calculator.

Examine different platforms such as PancakeSwap, ARMswap, Curve, or Uniswap; however, always consider risks such as temporary loss. Anyone may become a part of the DeFi revolution thanks to liquidity pools. You're invited to join the decentralized financial future.